They Did it Again

A few months ago, the Federal Reserve made it clear that, given that the recovery was more or less on track, it was going to start raising interest rates off their 46-year low. It did so at its most prior meeting in June, raising the federal funds rate -- the interest rate banks charge each other for overnight loans -- from 1 percent to 1.25 percent. Today they went up another 0.25 percent to 1.5 percent.

Why'd the bank do it?

The June decision announced (in Fed-speak) that the Fed was going to continue boosting rates; the consensus was that, barring a big economic surprise, it'd probably keep at it for a while. If anything, it was suggested, the Fed might have to raise rates less incrementally than it'd like to.

Then life got complicated for our friends on the Federal Open Market Committee (FOMC), the group, chaired by Alan Greenspan, that makes these decisions.

First, economic reports began to show soft spots in the economy. Most importantly, the job market began to weaken, adding progressively fewer jobs per month in April, May, and June. Then, at the end of last month, we learned the economy had grown by only 3 percent in the second quarter, well off the 4.5 percent rate of the first quarter. Wage growth was slowing; consumer spending -- the culprit in the GDP slowdown -- dipped in June. Inflation, a big motivator for the FOMC's increase, has of course been rising, but mostly due to oil prices rather than to any hint of economic overheating.

Greenspan dubbed all of this to be a temporary “soft patch.”

Then came a very big surprise. Last Friday, we learned that the nation's firms added only 32,000 jobs in July, the worst month for job growth this year. The soft patch seemed to be spreading, and many of us began to wonder if even these small rate hikes were warranted.

Today's statement acknowledges these concerns, but states a belief that the economy is “poised to resume a stronger pace of expansion going forward.” The FOMC agrees that “growth has moderated and the pace of improvement in labor market conditions has slowed,” but pins most of the problem on higher energy prices. It maintains that “even after this [rate hike], the stance of monetary policy remains accommodative.”

That said, my concern, and that of many others comes from the fact that rate hikes work their magic by slowing down economic growth (here's a nice graphic on how this works). Now, many have argued that by moving off such low rates, the FOMC is easing up on the accelerator more than putting on the brakes. Fair enough. But, at least as far as the job market is concerned, why would you want to decelerate when you're already crawling?

Here are a few reasons:

  • The Fed said -- again, not in so many words -- it would raise the rate. If it then didn't, that would signal to the world that the Fed thinks the economy is in worse shape than it's recently maintained.
  • The real interest rate equals the nominal rate minus inflation. The Fed sets the nominal federal funds rate; given that consumer inflation is running at around 3 percent, the real rate is negative. Under such conditions it's cheaper to borrow than to stand pat. That's highly stimulative, and you don't want to be there if you think growth is adequate.
  • This concern is less relevant now, but if investors feel the Fed isn't aggressive enough on the inflation threat, they'll add a risk premium to long-term interest rates. And that can hurt growth.

Then there's politics. Though the Fed claims not to be influenced by political concerns, this is, after all, Washington.

As Randall Dodd, director of the Derivatives Study Center, points out, this is the FOMC's second-to-last meeting before the election. If the FOMC chose not to raise now, especially after signaling previously that it had planned to do so, it could have been interpreted as a bald-faced attempt to boost the economy to help the incumbent president. If more bad news comes in, it can hold fast (i.e., not raise) at the next meeting with a bit more impunity, especially if the Fed continues to warn about economic weakness, as it did in today's statement.

But there's another side to this political calculation. Despite evidence to the contrary, George W. Bush is running around the country claiming the economy is “strong and getting stronger.” For Greenspan to contradict him by not raising today would have deeply undermined the president's credibility. Had the FOMC held fast today, imagine Bush officials trying to square this action with the president's rhetoric.

But should rates have been raised?

I've just walked around the office here and completed a highly scientific poll of EPI economists. We all said “no,” they shouldn't have been raised, except for one of us who thought that holding steady would have sent too negative a message to the markets. For the rest of us, letting up on the accelerator at a time when the job market is so weak trumped other concerns.

It's not too hard to tell where the FOMC comes down on the job market. Today's statement ended with a warning that the committee reserves its rights to “respond to changes in economic prospects as needed to fulfill its obligation to maintain price stability.” Note the glaring omission of “and full employment” at the end of that sentence.

Jared Bernstein is a senior economist at the Economic Policy Institute (EPI) in Washington, D.C.

You may also like