The U.S. economy is improving. Total nonfarm payroll employment rose by 255,000 in July, continuing a streak of fairly strong growth.
The unemployment rate is trending below five percent, which many economists consider to be “full employment.” Consumers are spending and feeling fairly confident, and the real estate market is generally healthy. Given the flurry of good news amidst relative stability, it’s only a matter of time before the Federal Reserve (Fed) raises its target interest rate.
It’s not a simple process. When the decision to raise rates is made, the Fed will engage in buying and selling bonds through Federal Open Market Committee (FOMC) operations. The intent is to shift the “federal funds rate,” which is the market-driven interest rate at which banks loan their extra balances with the Fed to other banks. When the Fed sells bonds, money is removed from circulation as purchasers (often banks) trade in money in exchange for bonds. With less excess cash in the economy, interest rates will tend to rise.
At the same time, when the federal funds rate is higher, banks tend to keep more reserves with the Fed (rather than loaning them out, for example), thereby further decreasing investment. With a lower federal funds rate, by contrast, banks have less incentive to hold on to reserves and are thus more likely to lend them out, encouraging investment. Unless and until rates rise substantially above current levels, any major adjustments in activity are unlikely.
The federal funds rate indirectly affects all other interest rates in the market, including rates for short or long-term loans, mortgages, and credit cards. Lower interest rates encourage economic growth by making credit more affordable, thus stimulating investment and major purchases such as housing. As interest rates begin to rise and borrowing becomes more expensive, these investments will slow to some extent.
The trick (as with any monetary policy effort) is to know when to take action. Up to now, the feeling (heavily encouraged by Wall Street) was that interest rates needed to stay low to continue to support job growth. However, if interest rate targets aren’t changed in time, numerous problems can arise such as inflation, which in turn contributes to higher long-term interest rates, curtailed investment, and other difficulties.
It looks like we are getting close to the next rate increase. In an August 26 speech in Jackson Hole, Federal Reserve Chair Janet Yellen provided some insight into the current thinking. She mentioned continued expansion of the U.S. economy and growth in household spending, as well as improvement in the labor market and labor utilization. However, she also noted less positive factors such as soft business investment and subdued foreign demand due in part to the appreciation of the dollar since mid-2014.
The most obvious statement of intent was that “the FOMC continues to anticipate that gradual increases in the federal funds rate will be appropriate over time to achieve and sustain employment and inflation near our statutory objectives” based on expectations of moderate growth in real gross domestic product (GDP), additional strengthening in the labor market, and inflation rising to two percent over the next few years. Chair Yellen went on to say that “in light of the continued solid performance of the labor market and our outlook for economic activity and inflation, I believe the case for an increase in the federal funds rate has strengthened in recent months.”
The ultimate decision will depend on whether incoming data continues to confirm this outlook. If conditions deteriorate, the normalization of monetary conditions will take longer. It is important that the Federal Reserve proceed with caution in raising rates, as too much too fast could stifle future growth. On the other hand, the Fed’s balance sheet is bloated with $4.5 trillion in bonds, probably at least three times what is needed to support an economy the size of the US, and realignment needs to occur. It is a delicate balancing act which will affect both short-term and long-term economic performance.
If we continue to see relatively strong job growth and other positive signals, though, I think we can look for an increase in the target interest rate within the next few months. It is a needed step toward monetary policy normalcy, both improving the Federal Reserve’s balance sheet and ensuring inflation remains under control.