Why Raising Interest Rates Has Been Such a Tough Call for the Fed

Photo

CreditMinh Uong/The New York Times

When the Federal Reserve raised its benchmark interest rate last December after keeping it near zero for seven years, Fed officials were in general agreement that they might increase rates as many as four times in 2016.

They thought the United States economy was finally strong enough — and the prospect of inflation close enough — that it was time to start raising interest rates back toward the level regarded as normal before the financial crisis.

But the economy did not follow that script. The Fed has not raised rates once this year, and it’s unclear when it might do so.

Economic growth has continued, but it has not accelerated. There is still no sign of stronger inflation. And, more broadly, Fed officials have increasingly concluded that the world itself has changed. They no longer expect to return interest rates to precrisis levels. As a result, they are no longer in as much of a hurry to get started.

As Fed policy makers look ahead to their meeting on Sept. 20-21, they are increasingly divided over the best way forward. Some say the time has come for another increase in the Fed’s benchmark rate. A number of these officials are particularly concerned that low rates are encouraging excessive speculation in areas like commercial real estate. Others, however, argue that the economy is still benefiting from low rates – and, in the absence of inflation, they see little reason to pull back.

Janet L. Yellen, the Fed’s chairwoman, must extract a consensus from her increasingly fractious committee. She has offered relatively little insight into her own views. In a speech in August, she said the case for raising rates had “strengthened,” but she did not answer the crucial question: Strong enough? Or not yet?

Mistiming a rate increase has consequences. If the Fed moves too soon, it could derail what remains a relatively weak economic expansion. If it waits too long, it could be forced to hit the brakes even harder.

1. Photo

   

   Janet L. Yellen, the Fed’s chairwoman.CreditDrew Angerer for The New York Times

   The Fed is wrestling with three big, intertwined questions:
2. 1. How many people want jobs?
   During an economic recovery, the number of people who can’t find work gradually dwindles. Employers start chasing applicants. Wages start to rise. And the Fed starts raising interest rates to prevent the economy from overheating.

   Seven years into the current recovery, the unemployment rate has fallen to 4.9 percent, a historically normal level, but the rest of the picture doesn’t look quite right. The unemployment figure counts only people who are actively seeking work, but millions of adults remain on the sidelines.

   By keeping rates low, the Fed could draw more of those people back into the work force. And so far there is no sign of overheating.
3. ​2. How low are interest rates?
   The Fed cut its benchmark rate by five percentage points in response to the Great Recession. That is five points of stimulus, right? Well, Fed officials are increasingly convinced that it has become more like three points of stimulus.

   Global interest rates are in a historic swoon. The problem can be described as a glut of money or an absence of attractive investment opportunities. The consequence is a narrowing gap between the market rate and the Fed’s benchmark rate.

   That means the Fed is providing less stimulus than it thought, which in turn means it doesn’t need to pull back quite so quickly, since it doesn’t have as far to go. But …
4. ​3. What damage is done by doing nothing?
   The Fed usually increases rates because it fears inflation, and inflation remains sluggish, in part because of the weakness of the global economy. But Fed officials have other worries. Notably, they are worried about creating future financial crises.

   Low rates are intended to encourage financial speculation. But too much risk-taking is not a good thing. And the longer rates stay low, the greater the risks. Fed officials have highlighted some areas, like commercial real estate, but they are also worried about the problems they cannot see. After all, the next crisis usually comes from a different place than the last one.

   This fear of the unknown has become a major argument for moving more quickly to raise the benchmark rate.
5. 
   
6. Same Numbers, Different Meanings
   Although their meetings are closed to the news media and the public, Federal Reserve officials are economic experts who often like to express their views in speeches and interviews. And although they are all looking at the same numbers, they come away with different judgments about raising interest rates. Behind nuanced, technical language, a debate has played out among Fed policy makers in recent weeks.
7. Lael Brainard: In Favor of Patience
   Member of the Fed’s Board of Governors, speaking Sept. 12.

   “Although we have seen important progress on employment, this improvement has been accompanied by evidence of greater slack than previously anticipated. This uncertainty about the true state of the economy suggests we should be open to the possibility of material further progress in the labor market.”

   TRANSLATION: We predicted inflation would be rising by now, but it’s not. It turns out the supply of people looking for work was larger than we thought. Let’s keep our foot on the gas.
8. Eric Rosengren: It’s Time to Gradually Raise Rates
   President of the Federal Reserve Bank of Boston, speaking Sept. 9.

   The Fed’s current “degree of accommodation increases the chances of driving the core inflation rate closer to the Federal Reserve’s 2 percent target, but it also increases the chances of overheating the economy. So if we want to ensure that we remain at full employment, gradual tightening is likely to be appropriate.”

   TRANSLATION: There can’t be that many more people looking for work. If we wait to raise rates, we may to have to increase more sharply — and that could cut the recovery short. Better to start now, so we can do it slowly.
9. 
   

10. 

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    Ben S.

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    Janet L.

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    Note: Rate is the federal funds rate until Sept. 27, 1982, the federal funds target rate until Dec. 15, 2008, and thereafter the upper limit of the federal funds target rate range.

    By The New York Times

    Life in a Low-Interest World
    It seems like a distant fever: In the late 1970s and early ’80s, energy prices soared and the inflation rate rose into the double digits, spiking at nearly 15 percent. To bring inflation under control, Paul A. Volcker, as Fed chairman, pushed the benchmark rate up to 20 percent (and home buyers looking for a 30-year fixed mortgage paid up to 18 percent). The higher rates plunged the economy into a deep recession.

    Since then, inflation has fallen sharply, but the economy has had a harder time delivering broad-based prosperity as inequality has widened and incomes for most Americans have stagnated. This pattern has continued even as the United States has slowly recovered from the collapse of the housing market and the subsequent financial crisis.

    Fed officials, like sailors trying to make headway on a windless sea, have resorted to a number of extraordinary measures, including pumping trillions of dollars into the banking system and leaving short-term rates near zero for years, in an effort to revive the economy. But the Fed’s inability to restore growth to historical levels has exposed shortcomings in current macroeconomic theory and set off a vigorous debate over how to navigate a changing economic environment.

    Putting the United States in a global frame, Ms. Yellen recently discussed the “marked decline” in the interest rate levels necessary to bring about maximum employment and output. The reasons are varied, she said: a slowdown in population growth in many countries, smaller productivity gains and a “decreased propensity to spend” because of various financial crises around the world since the late 1990s.

    But in an admission that underscored the Fed’s difficult position, she expressed how difficult it is to see into the future.

    “Our understanding of the forces driving long-run trends in interest rates is nevertheless limited,” she said, “and thus all predictions in this area are highly uncertain.”
    To learn more about the issues the Fed is wrestling with, read the full text of the speeches mentioned above:

    + Janet L. Yellen: “The Federal Reserve’s Monetary Policy Toolkit: Past, Present, and Future”

    + Lael Brainard: “The ‘New Normal’ and What It Means for Monetary Policy”

    + Eric S. Rosengren: “Exploring the Economy’s Progress and Outlook”

    For more background and perspectives on the Fed and the United States economy, from The Times and elsewhere:

    + “Yellen Sees Stronger Case for Interest Rate Increase,” on Janet Yellen’s outlook leading into the September Fed meeting.

    + “What Happens When the Fed Raises Rates, in One Rube Goldberg Machine,” a whimsical, enlightening video from The Upshot.

    + “Why Are Interest Rates So Low?” an essay by Ben S. Bernanke, the former Fed chairman. (Brookings.edu)

    + “The Fed Is Searching for a New Framework. New Minutes Show It Doesn’t Have One Yet,” an analysis of the questions raised in Fed officials’ closed meetings. 

    + “Changes in Labor Participation and Household Income,” a look at some reasons why fewer people are looking for work, from the Federal Reserve Bank of San Francisco. (Frbsf.org)

    + “A History of Fed Leaders and Interest Rates,” ranging from Paul Volcker to Janet Yellen.