BUSINESS

The Fed Raises Key Interest Rate, Potentially Slowing Job Market Growth

The central bank's long-awaited decision will hit you in your wallet.

17/12/2015 6:01 AM AEDT | Updated 18/12/2015 6:24 AM AEDT

WASHINGTON -- The Federal Reserve announced Wednesday that it is raising its benchmark interest rate, putting downward pressure on job creation in order to address long-term concerns about inflation and financial stability.

The central bank’s Federal Open Market Committee decided to raise the target federal funds rate -- or the interest the Fed sets for banks to lend to one another overnight -- one-quarter of a percentage point to a range of 0.25 percent to 0.5 percent.

Fed officials expressed confidence that the job market is finally growing enough that it will soon put upward pressure on prices.

"The Committee judges that there has been considerable improvement in labor market conditions this year, and it is reasonably confident that inflation will rise, over the medium term, to its 2 percent objective," the FOMC said in its official statement.

Speaking at a press conference after the announcement, Federal Reserve Chairwoman Janet Yellen said that if the Fed were to wait much longer, “we would likely end up having to tighten policy relatively abruptly at some point to keep the economy from overheating and inflation from significantly overshooting our objective.” Raising the interest rate abruptly, Yellen said, would increase the risk of pushing the economy back into recession.

Yellen also alluded to fears that keeping the key interest rate at or near zero would deprive the Fed of the ability to respond to "adverse shock" in the economy by cutting interest rates further.

“It would be nice to have a buffer, in terms of having raised the federal funds rate, to a certain extent to give us some meaningful scope to respond” to a downward turn, Yellen added. “That is an important consideration for the committee.”

The federal funds rate is used as a benchmark for interest rates on virtually all credit, including home mortgages, automobile loans and student loans, giving it far-reaching influence over the economy.

The Fed lowers the federal funds rate to boost employment by reducing borrowing costs. It raises rates to slow job market growth, when it believes the country is at or near what it calls full employment -- the level of job creation the economy can tolerate without stoking excessive price inflation.

It's a testament to the depth of the Great Recession and fragility of the recovery that until Wednesday, the federal funds rate had remained at zero to 0.25 percent since December 2008. 

Speaking at a press conference after the announcement of the interest rate hike, Federal Reserve Chairwoman Janet Yellen said that if the Fed were to wait much longer, “we would likely end up having to tighten policy relatively abruptly at some point to keep the economy from overheating and inflation from significantly overshooting our objective.” Raising the interest rate abruptly, Yellen said, would increase the risk of pushing the economy back into recession.

Yellen also alluded to fears that keeping the key interest rate at or near zero would deprive the Fed of the ability to respond to "adverse shock" in the economy by cutting interest rates further.

“It would be nice to have a buffer, in terms of having raised the federal funds rate, to a certain extent to give us some meaningful scope to respond” to a downward turn, Yellen added. “That is an important consideration for the committee.”

The European Central Bank, by contrast, continues to escalate its monetary stimulus efforts, leading some to worry that the dollar could appreciate in value too much relative to the euro, hurting U.S. manufacturing and creating other risks for the global economy.

Nonetheless, the Fed’s initial quarter-point increase is in itself unlikely to have a major impact. And the widely anticipated move will not come as a shock to investors, who have already priced it into their calculations. But if Wednesday's rate hike lays the groundwork for a series of future increases, it would have much more significant implications for the economy.

The Fed’s FOMC indicated that it will continue to exercise caution. It did not commit to raising rates consistently, saying instead that it would “monitor actual and expected progress toward its inflation goal” before deciding to raise rates once again.

“The Fed is really trying hard to move as slowly as possible so the economy has time to absorb those movements without it having a big economic impact,” said Tara Sinclair, chief economist at the job search website Indeed.com. “They are not putting on the brakes, just giving less gas.”

The Fed is really trying hard to move as slowly as possible so the economy has time to absorb those movements without it having a big economic impact... They are not putting on the brakes, just giving less gas. Tara Sinclair, chief economist, Indeed.com

The central bank can point to steady job growth to justify its decision. The economy has, on average, created 237,000 jobs per month in the past 12 months, bringing the official unemployment rate down to 5 percent.

Yellen rejected the notion that the economic expansion is due to expire because it has already lasted as long as many previous boom cycles.

"I think it’s a myth that expansions die of old age,” Yellen said. “The fact that this has been quite a long expansion doesn’t lead me to believe that its days are numbered."

The failure of job market growth to boost inflation more significantly, however, has prompted some economists to counsel the Fed against raising rates. The price of consumer goods and services, excluding the more volatile costs of food and energy, rose 1.3 percent in the 12 months ending in October -- well below the Fed’s 2 percent target.

Josh Bivens, who studies Federal Reserve policy for the progressive Economic Policy Institute, called an interest rate hike a “mistake” in remarks at a Dec. 1 congressional briefing for that very reason.

Bloomberg/Getty Images
Members of the Fed Up campaign, a coalition of progressive groups opposed to an interest rate hike, demonstrate at the Jackson Hole symposium on Aug. 27, 2015.

Bivens and other, mostly liberal, economists who believe it is too soon for an interest rate hike argue that lackluster inflation is actually a sign that the Fed’s other area of concern, the job market, is not growing fast enough.

"I am against the hike, because to me you hike interest rates when you are trying to cool down an economy that is overheating and threatening to generate wage and price inflation," Bivens said in an interview this week. "There is just no evidence of that in the data. In fact, both wages and prices are growing much more slowly than they should be if the economy is healthy."

Counting people working part time because they cannot find full-time work, and those who have given up looking for work, the unemployment rate is actually 9.9 percent, according to the Bureau of Labor Statistics.

The larger number of job seekers for available job openings, Bivens and other liberal economists argue, helps explain why average wages have grown only 2.3 percent in the 12 months ending in November -- significantly less than year-over-year rates in the months before the recession. Prices will only begin rising in earnest once wage growth accelerates, they assert, which the Fed should allow by leaving rates unchanged.

Yellen acknowledged concerns about the pace of job market growth, agreeing that the official unemployment rate masks ways in which it is still not operating at capacity. She noted the "depressed level" of labor force participation, which includes people who have given up looking for work, and "somewhat abnormal" levels of part-time employment. "Wage growth has yet to show a sustained pickup," she said.

But the FOMC, which Yellen leads, said on Wednesday that it is forecasting that inflation will reach 2 percent in the medium term. Fed officials acted now, the committee said, "recognizing the time it takes for policy actions to affect future economic outcomes." 

Yellen addressed the issue of below-target inflation at Wednesday's press conference. "With inflation currently still low, why is the committee raising the federal funds target?" she asked. 

Fed officials believe that low energy prices and a strong dollar are keeping inflation temporarily low, Yellen said.

Sinclair, who also teaches economics at George Washington University, noted that the rock-bottom interest rates can create uncertainty for businesses concerned about when rates will ultimately rise.

“The Fed is working toward predictability and stability overall,” Sinclair said. “Bringing the interest rate back to more historical norms is helpful for companies to make plans.”

Predictability is one reason Mike Brey, president and CEO of the Maryland-based retail chain Hobby Works, said he believes a rate hike now, though painful, may ultimately be better than delaying it.

I feel the exact same way I feel about the economy as I do about the Redskins: I need to see a lot more before I am a true believer. Mike Brey, CEO & president, Hobby Works

“We are enjoying low interest rates and if things continue this way, we’d be seriously looking at opening another store and low rates would really help us,” Brey said. “It seems like [a rate hike] has to happen eventually, though, so part of me wants it to happen very slowly and eventually. My worry is that we do nothing for a while and then suddenly we do a lot.”

This year has been Hobby Works' best since before the recession, Brey said. The store, which has several locations in the Maryland and Virginia suburbs of Washington, increased its payroll 15 percent to accommodate rising demand for its products -- particularly its popular recreational drones.

But Brey said he remains “torn” about the Fed’s decision, because he worries that congressional dysfunction may thwart his business’ progress once again. He had a similarly good run in 2011, but he said Congress’ last-minute government shutdown negotiations that produced the across-the-board spending cuts known as sequestration depressed consumer confidence anew at the end of the year and well into 2012.

Brey said he feels “the exact same way I feel about the economy as I do about" Washington's NFL team. "I need to see a lot more before I am a true believer.” 

This story has been updated with additional comments from Janet Yellen.

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