Goodbye Zero Rates, Welcome Nearly-Zero Rates

For the first time in nearly a decade, the U.S. Federal Reserve on Wednesday raised its benchmark lending rate by 25 basis points. Some observers described the move as putting an end to an extraordinary era of near-zero interest rates in an attempt to restore the country’s economy to health after the financial meltdown in 2008. But, was it really the case?

Originally, I was prepared to argue against a rate hike in the Fed’s main rate, but the statement released following the Federal Open Market Committee (FOMC) meeting made me wonder why it did what it did. In this essay, I will try to explain the Fed’s motivation and the policy implications behind its decision.

The Statement

The FOMC raised the federal funds rate to a target range of 0.25 percent to 0.5 percent. The statement indicates an expansion of economic activity “at a moderate pace” and an improvement in labor market indicators confirming that underutilization of labor resources “has diminished appreciably” in recent months.

On the other hand, the FOMC acknowledges that inflation continues to run below the 2-percent objective and, most importantly, that longer-term inflation expectations have edged down. Inflation is therefore nowhere near target. Even if it remains unusual for the Summary of Economic Projections (SEP) to forecast inflation to be above target, the Fed does not expect inflation rate to hit 2% before 2018!

Still, the key point in the Fed’s statement is the following: “The stance of monetary policy remains accommodative after this increase[.]”

Policy Implications

Normally, raising interest rates is a form of a contractionary monetary policy, but not this time. Of course, I am not arguing that this key rate hike will have no effect. It is worth noting that in spite of the decrease in the utilization of labor resources, the U.S. economy is not fully back to health. Low labor force participation rate and high part-time employment levels point to a remaining slack in the labor market. However, the difference between 0 % and 0.25 % is not a big deal in my opinion. As Fed rates increase, mortgage rates and other borrowing costs are likely to rise too, but the relationship is not mechanical and it is unlikely that banks will quickly pass the costs on to their customers. In anyway, financial markets took the news calmly as investors were expecting the move.

Beyond the U.S economy, two main concerns prevail. First, the Fed will be facing the challenge of increasing domestic rates while other major central banks are holding rates low with all the implications for the international monetary system. Second, as small as it is, this increase will have an impact on emerging economies through two channels: it will add to the capital outflow pressures and it will hit firms with U.S.-dollar denominated bonds.

Bottom line

Whatever concerns about or arguments against the rate hike one might have, it is simply hard to argue that interest rates should be zero when unemployment rate is 5% and falling (4.7% in 2016 according to SEP).

It should be pointed out though how the Fed states that its main rate is likely to remain below expected long-term levels “for some time.” This means the FOMC is taking on board the view that the neutral interest rate has been falling, as argued by Larry Summers and others.

My guess is that the Fed moved from keeping interest rates at zero for 7 years, to keeping interest rates near-zero for a long time. We simply said goodbye to zero rates to officially welcome nearly-zero rates.

Thanks for reading. Please share if you like it. Comments are welcome.

To stay up-to-date on my posts, click the follow button at the top of this post and follow me on Twitter. I tweet @rami_kiwan.