The Rate Hike Tug-of-War
There has been a lot of talk in the news recently about the Federal Reserve, when they’re going to raise rates, and what it will do to the stock market. At first glance, it seems that raising the rate will cause a market selloff making it sound like a terrible event to be postponed as long as possible. You may have also read that the Fed will only raise rates once they deem our economy to be healthy and growing, which makes it sound more like a vote of confidence. All of these varying statements make the whole situation sound rather confusing. Is a rise in rates good or bad? As is the answer with most economic instances – it’s not quite that simple. Does that mean we should throw in the towel and give up in our attempt to understand what is really going on with the Federal Reserve? Of course not! In our continued effort to educate our clients, we wanted to take a moment to clarify some aspects of the federal funds rate and its current trajectory that will hopefully help you make greater sense of all the jargon in the news. We’ve also included several links to additional articles at the end of this one that you may find helpful in furthering your fed funds rate education.
The following chart shows changes in the federal funds rate that occurred during the last ten years:
You’ll notice several things. One, the rate hasn’t changed since the Federal Reserve responded to the crisis in 2008 by lowering it to zero. They have been relatively quiet since then as the economy has recovered. Secondly, you’ll notice that the Fed was decently active in raising rates in 2005 and 2006. Do you remember hearing much about those rate raises? Probably not, because the media didn’t make as big of a deal about it. While I only pulled the last ten years, you can find a more complete list of all the times the Fed has raised or lowered rates since 1971 here: New York Fed: Historic Changes to the Federal Funds Rate.
As I’ve mentioned in previous articles, it’s always helpful to take a step back and gain some perspective. Moving the rate will have some effect on the economy, but always remember that the media likes to hype things up to get your attention so you’ll watch their shows and buy their papers. In reality, most economists and analysts (certainly the good ones) have known that a rate hike was coming and have already factored that into their research and outlooks. The market has also largely already factored in a rate hike. Remember, the market responds to news about events when the news comes out, which is different from responding when the event happens. When events shock the market it’s usually because some aspect of what happened was a surprise – either positive or negative. We know a rate hike is coming. That isn’t a surprise. We just don’t know when it will be or how much it will be, but as the Federal Reserve shares more and more information with the public about what it intends to do, the market will adjust to that information.
A good question that hasn’t been well addressed is why the rate should be raised. Part of the Federal Reserve’s dual mandate, or job, is to manage inflation – how much prices increase or decrease. One of the ways they do that is by setting the federal funds rate. This is where the analogy of tug-of-war comes in. On the one hand, the market has enjoyed an incredible amount of growth since the financial crisis. Additionally, the economy has largely recovered. Unemployment has fallen. People are spending again. Builders are building. This growth has the potential to significantly push up prices, thereby causing inflation. The Fed has a mandate to respond to that potential for inflation by raising rates, which they have given the impression they will do gently. On the other hand, there are things going on that are holding us back from inflation. Unemployment is falling, but wages aren’t necessarily rising. In addition, oil prices have plummeted and the dollar has strengthened. These are all things that hold us back from inflation and, in extreme cases, can cause deflation. Furthermore, while the U.S. has been growing, the rest of the world hasn’t, and in many places is in danger of falling into deflation, if they’re not there already. Thus, we have our tug-of-war: we want to continue encouraging our economy to grow by keeping inflation at a moderate pace, but we don’t want to move too soon for fear that in our haste we will actually steer ourselves towards deflation.
While there are many more variables involved, hopefully, this explanation of both sides of the argument can help you make greater sense of what’s going on in the news. If you’d like a more in-depth explanation of the federal funds rate, feel free to give one of our advisors a call or check out the following articles that I personally found helpful in understanding this topic.
“Inflation, The Fed, and the Big Picture” – Carmen Reinhart, Professor of International Financial Systems at Harvard via Project Syndicate
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