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When 2015 began policymakers figured that the U.S. Federal Reserve would raise interest rates. Optimism about the strength of the U.S. economy, as well as projections that inflation would soon meet the Federal Reserve’s preferable mark of 2%, lent credence to these predictions. However, lower than expected growth during the first quarter, coupled with disappointing unemployment data and stubborn inflation statistics have caused some observers to change their predictions of a rate increase. Instead of expecting an increase in 2015, some are now saying that a change in monetary policy will not occur until next year. The minutes of the Federal Reserve’s meeting last month show that it is divided about what to do and this uncertainty means that extempers could face questions over the next three months about when the Federal Reserve will act, and if it should raise interest rates before the end of the year.
This topic brief will give an overview for how monetary policy works, discuss why “hawks” within the Federal Reserve wish to raise interest rates, and then analyze why “doves” within the Federal Reserve wish to maintain interest rates at their near-zero level for the near future.
Readers are also encouraged to use the links below and in the related R&D to bolster their files about this topic.
How Monetary Policy Works
Before extempers can talk about the economic impact of the Federal Reserve’s decisions, it is important that they understand what monetary policy is, how it is created, and how it affects the economy. In the United States, monetary policy is set by the Federal Reserve, a body created by the federal government in December 1913 in the aftermath of the Panic of 1907. It is headed by a chairman, who is appointed by the President of the United States and confirmed by the Senate. The President also appoints seven members of the Federal Reserve’s Board of Governors, which serve fourteen year terms after being confirmed by the Senate. The Federal Reserve is composed of twelve districts throughout the United States, each of which is headed by a Federal Reserve president, and these districts help to process decisions made by the Fed’s Board of Governors, as well as clear checks in the financial system. The most significant part of the Federal Reserve is that its decisions are insulated from politics. In some cases, American presidents such as Richard Nixon and Jimmy Carter wished for the Federal Reserve to adopt a different policy direction. However, the Federal Reserve is not beholden to a political constituency and their decisions are meant to be independent. This prevents politicians from trying to manipulate the federal money supply in an effort to assist in their re-election (this is a problem in other countries such as those in Latin America which have suffered bouts of inflation due to a lack of central bank independence).
The Federal Reserve is tasked with attempting to stabilize the economy and shaping long-term interest rates. This adjustment of interest rates to help grow or restrain the economy, which controls how much money flows through the economy, is what is meant by the term “monetary policy.” Extempers who struggle with understanding monetary policy should keep one valuable thought in mind: the more money that is flowing through the economy is usually better for economic growth because it provides money for investment in property, businesses, stocks, and other financial instruments. The less money that is available in an economy has the opposite effect as there is less money for investment, which can hinder growth. However, the trick for the Federal Reserve is to balance the money supply so that inflation – the general rising of prices – does not get out of control. Economists generally agree that a 2% inflation rate is normal. Going too far below this mark presents the fear of deflation – a general lowering of prices – which is bad for the economy as people might refuse to spend if prices continue to go down, thereby harming the profits of businesses. Going in excess of 2% presents the risk of inflation getting out of control, which can erode the buying power of consumers as their money means less. For example, if someone was making $100 at their workplace each day, but inflation meant that the costs of housing, food, and gasoline were in excess of this number for their daily commute and cost of living, then there would be a significant problem for them. Thus, the Federal Reserve seeks to make sure that there is enough money in the economy to ensure long-term economic growth, while also tempering inflationary risks that can create economic instability.
The tool used most by the Federal Reserve to control the money supply is interest rates. Generally speaking, high interest rates are a way for the Federal Reserve to limit the amount of money in the economy by making it more costly for businesses and consumers to get loans. For example, if someone wanted to borrow $100 at 10% interest, this means that they would have to pay back a bank $110 (or basically ten cents on every dollar borrowed). Higher interest rates also reward saving, so it is an incentive for consumers to leave their money in savings accounts and other financial instruments that bear an interest rate. Conversely, low interest rates encourage businesses and consumers to take out loans. If someone wanted to borrow $100 from a bank at 1% interest, then they would only have to pay the bank back $101 (or one cent on every dollar borrowed). This means that there is practically little cost to borrowing, so businesses might take out loans for expansion or consumers might take out loans for home improvement projects or a mortgage (which can help the housing market). In addition, low interest rates are a disincentive for consumers to save since savings accounts bear very little interest. For example, if interest rates are below the rate of inflation then consumers are better off spending their money in the economy rather than leaving their money to languish in a bank account as the purchasing power of that money will erode over time. Therefore, high interest rates are a way for the Federal Reserve to restrain economic growth and curtail inflation by limiting the amount of money in the economy, whereas low interest rates are a way to encourage economic growth via investment and spending. When the U.S. economy needs a stimulus, the Federal Reserve will cut back interest rates. If the Fed believes that the U.S. economy is growing too quickly, though, or if inflation is getting out of control, they will opt to raise interest rates.
There are many ways that the Federal Reserve attempts to influence interest rates in the U.S. banking system. One tool is the reserve requirement, whereby the Federal Reserve mandates that banks have to keep a certain fraction of deposits on hand to meet their obligations. For example, the Fed might require a bank to keep 10% of its deposits on hand, which means that if a bank had deposits of $5,000 collectively from its customers that it must keep $500 in its vaults. A higher reserve requirement constitutes a more restrictive monetary policy as banks are not able to loan as much money out for other operations due to needing to retain a certain amount of money in their possession. A second tool is the discount rate, which is the rate of interest banks are charged for borrowing from the Fed. Banks have to borrow from the Fed at times to meet their reserve requirements at the end of a business day. If the Fed charges a higher rate of interest for borrowing, banks will be reluctant to keep their interest rates low for consumers because they need to find ways of possessing more money so as not to keep borrowing from the Fed. The last tool, and one that the Fed has used most often, is open market operations. This is when the Fed buys and sells U.S. securities in order to increase or decrease the money supply. These operations are very confidential because if it was known what the Fed was doing, other investors might try to manipulate the market since the government would be a primary purchaser. When the Federal Reserve wishes to increase the money supply using open market operations it buys bonds, which releases more money into the financial system. When it wishes to decrease the money supply, the Federal Reserve can then sell bonds, thereby taking money out of the financial system. Most of these transactions happen via computer today, so money that is created or eliminated during a particular period of time is largely artificial on a computer screen.
Through these and other tools, the Federal Reserve establishes the nation’s monetary policy. It is arguably one of the most transparent institutions in the world as it releases the minutes of its monthly meetings and announces when it intends to adjust the nation’s interest rate. Right now, interest rates are near 0% and have been this way since December 2008 when the Fed was trying to fight the Great Recession. The last time that the United States saw the Fed raise interest rates was 2006. An announcement by the Fed that they intend to raise interest rates would signal that they believe the economy is getting stronger, but it would also tell financial markets that an era of “easy money” at cheap rates of interest would be coming to an end. Conflicting projections of how a rate increase would affect the economy and investment climate is what is at the heart of recent Fed discussions of when a rate increase would be appropriate.
The “Hawk” Argument: Raise Rates This Summer
By definition, monetary “hawks” are those who wish to raise interest rates to thwart any signs of inflation regardless of its effect on unemployment (or the fear that raising interest rates may choke off economic growth prematurely). Voices within the Federal Reserve Board of Governors are trying to make the case in public, as well as behind closed doors, that raising interest rates before the end of 2015 would be in the country’s best interest. “Hawks” lost their effort to get the Fed to raise interest rates at its meeting last month, but they are hoping to win the argument in June.
One of the points made by those seeking an interest rate increase is that it will prevent new bubbles from forming in the economy. Economists who believe this include St. Louis Federal Reserve President James Bullard, who Market Watch reports on April 15 has been sounding warnings of how low interest rates are leading to too much speculative investment in the economy. Those who fear a bubble cite the 2008 financial crisis where a supposed reluctance by the Federal Reserve to raise interest rates exacerbated the unsustainable growth of the housing sector, which eventually triggered the meltdown of the financial system. They argue that too much money into the economy at low rates of interest will soon produce speculative behavior, once again creating an economic disaster. Reuters explains on April 16 that Boston Federal Reserve President Eric Rosengren recently stated in London that prolonged interest rates that are near zero may leave some developed economies, including the United States, vulnerable to future shocks, thereby necessitating that the Federal Reserve act sooner, rather than later, on interest rates.
Another argument for those in favor of raising rates is that the economy is improving and thereby justifies a rate increase. Typically, improved economic growth and hiring produce higher inflation as there is more money in the market via disposable income (from those hired) and businesses that are seeing better sales. Supporters of a rate hike such as Bullard argue that unemployment is set to fall into the 4% range by the end of the year, thereby creating the conditions necessary for a rate increase. San Francisco Federal Reserve President John Williams, who considers himself “a 2015 person” in terms of when a rate increase should occur, tells The New York Times on April 16 that although some recent economic figures have been disappointing – first quarter GDP growth is expected to have fallen to 1% to 1.5% versus fourth quarter numbers in 2014 that saw more than 2.2% growth – this was mostly due to a weather anomaly as the winter of 2014-2015 was one of the worst on record. Therefore, based on unemployment conditions, as well as optimistic projections of GDP growth for the rest of 2015, some within the Federal Reserve are calling for higher interest rates.
There are also some fears inside of the Federal Reserve that if interest rates are not raised soon that it will force the Fed to raise interest rates more quickly than it would like when the decision to raise rates is finally made. Cleveland Federal Reserve Bank President Loretta Mester tells The Wall Street Journal on April 16 that if the Federal Reserve raises interest rates this summer it will make it easier to tighten rates later since investors will have a clear picture about what the Fed intends to do. In other words, the Federal Reserve could face the choice of raising interest rates by 0.25% this June – the Fed would raise rates by this number if it does decide to act because Federal Reserve Chair Janet Yellen has already said that rate increases will be moderate – or raise them by a full percentage point later, which could roil financial markets that do not have enough time to adjust. Bullard agrees with this view as The Minneapolis Star Tribune writes on April 15 that “continued accommodation” with low interest rates is not good for the financial system, potentially creating a “witches brew” of uncertainty could produce harm to the economy. CNN reports on April 13 that acting gradually is in the Fed’s best interest because numerous rate increases within a calendar year could roil loan, bond, and mortgage markets. The Federal Reserve did raise rates several times in 1994, ending that year with a 0.75% rate increase and it did raise rates four times in 2006 as well. If the Fed intends to raise rates, CNN argues that its best strategy is to raise rates and then wait to see the economic consequences of its actions before proceeding further. Doing this before the end of 2015 would be preferable instead of possibly letting inflation get out of control and then having to raise rates by significant amounts. Most reports say that the Fed intends to achieve an interest rate near 3.5% by 2017, so going in small increments is the preferred strategy to get there.
Interest rate “hawks” also allege that greater changes are needed in the Federal Reserve system to make it more responsive to economic circumstances. In Congress, Republicans have proposed bills that would audit the Federal Reserve (an idea of presidential candidate and Kentucky Senator Rand Paul) or demand that it base its interest rates on mathematical calculations. USA Today reveals on April 17 that Republicans would prefer the Fed to align its monetary policy with the “Taylor rule,” which was created by Stanford University professor John B. Taylor. It argues that the Fed’s interest rate should be set according to levels of inflation and economic growth. Proponents say that this would eliminate personal preferences in the Fed’s decision-making process and Dr. Taylor argues that his rule would have produced a current rate of interest between 1.25-2%. “Hawks” use the Taylor rule as evidence for how the Fed is not acting quickly enough in light of present economic circumstances and potentially setting the U.S. economy up for failure when it finally does decide to act.
The “Dove” Argument: Delay a Rate Increase
The “hawk” argument for an interest rate increase is countered by “doves” within the Federal Reserve that prefer to see the economy rebound before they worry about inflationary concerns. Extempers who confronted questions about Janet Yellen taking over the Fed may remember that one of the criticisms leveled against her is that she is a “dove” and values the economy achieving full employment over cracking down on inflation. The “doves” recently won the March meeting over whether a rate increase should occur during the spring, but they will also have to win another battle in June if they wish to keep interest rates near zero.
The “doves” allege that even though some economic indicators look good in the economy, unemployment figures are not telling the full story. CNBC reports on April 16 that there are two ways of looking at unemployment. U-3 is an unemployment indicator that measures the total number of unemployed workers in the labor force, which only includes those who are actively looking for work. This number is currently at a thirty-six year low and the nation’s unemployment rate has fallen from 10% in October 2009 to 5.5% last month. The U-6 rate of unemployment takes into account workers that have dropped out of the labor force due to becoming discouraged about finding work and also factors into those who are underemployed (which refers to those who are working part-time but wish to work full-time). The U-6 unemployment rate is 10.9%. This is down from 17.1% at the height of the Great Recession, but it is still double the U-3 number. The Financial Times of London also explains on April 16 that GDP growth in the first quarter is slowing and it is uncertain whether this augurs for a long-term trend of disappointing growth in 2015. The “hawks” are willing to write off the first quarter as an anomaly, but “doves” are not so certain. The Wall Street Journal by way of The Australian Business Review writes on April 18 that the first quarter saw reduced consumer spending levels in retail stores, reduced industrial output, and slower-than-expected growth in homebuilding, so this may hurt economic momentum going into the second quarter. Bloomberg notes on April 16 that Atlanta Federal Reserve President Dennis Lockhart is wary of raising rates in the present cycle, arguing that not only did economic growth cool in the first quarter, but only 126,000 jobs were added in March. This was the smallest gain since December 2013 and may show that the economy is not strong enough to weather a rate increase. According to the BBC on April 8, the growing strength of the U.S. dollar may also create problems for the economy since it will make U.S. exports more expensive overseas, potentially slowing down economic growth domestically and thereby giving “doves” another reason to oppose raising rates in the present climate.
Furthermore, “doves” argue that it is not yet clear that inflation is moving in excess of 2%, which would trigger more aggressive federal action on interest rates. Forbes explains on April 17 that the annual rate of inflation went from 1.8% to 1.7% in February and Bloomberg on April 17 points out that consumer prices excluding food and fuel rose 1.8% in March, which might be evidence in favor of a rate increase since inflation is approaching the 2% target. However, The Wall Street Journal notes on April 12 that core inflation, which excludes food and energy, has been stuck at 1.3-1.7% since the middle of 2012 and that inflation that includes food and fuel prices has been 0%. Tepid wage growth in the economy has also bottled up inflation. Additionally, The Wall Street Journal explains that some economists do not think inflation will reach 2% until 2017. According to Fortune on April 8, the Fed does not understand why inflation has been so stubborn in light of other growth in the economy, but they point to the lack of wage increases, the effect of foreign imports in the economy, and low fuel prices as possible reasons. Why the Fed has to be cautious is that if it raises rates without the presence of significant inflation it could give consumers a disincentive to spend in the economy, as some may prefer to save, thereby igniting deflation, a problem that is much more difficult for governments to tackle.
There is a great deal of uncertainty about what the first Federal Reserve decision to raise rates will have on the economy as well, which some “doves” are using to support a reconsideration of moving on rates by the end of the year. The Guardian on March 19 writes that some investors are already preparing for a rate increase by taking money out of U.S. Treasury securities in anticipation of moving that money toward riskier ventures that may pay a higher rate of interest. In fact, investors as of the middle of last month have taken out $6.1 billion from Treasury security markets. The UK Telegraph reveals on April 15 that global corporate bonds could be in danger of default if the Fed begins raising interest rates because many of these bonds were taken out when interest rates were low. The energy sector could face the brunt of changes in monetary policy due to lower-than-expected incomes due to falling global oil prices and the excessive amounts of debt that have built up in that sector. The International Monetary Fund (IMF) is already warning of a “cascade of disruptive adjustment” if the Fed moves on interest rates, but is likely that this adjustment will have to take place soon. Interest rates will not remain low forever, but in light of global economic conditions, especially low oil prices, higher rates could spell disaster for oil firms hoping to receive new financing to thwart bankruptcy.
Extempers should continue to monitor the U.S. economy so that they can best answer questions about what the Fed is likely to do in June. If second quarter GDP numbers look good, the U-6 unemployment number is falling, and there are indications that inflation is nearing 2%, then it is likely that the Federal Reserve will raise rates. However, if the U-6 unemployment rate remains stubborn or that inflation does not look to be moving beyond its present threshold, there are significant doubts about whether the Federal Reserve will move on rates this summer. A rate increase is inevitable, but the strength of the U.S. economy will dictate what the Fed does and at present, a rate increase is just as uncertain as the continued performance of some segments of the U.S. economy.