Fed Contemplates Higher Interest Rates

By Samantha Torre

As a result of the U.S. economic recession of 2008, short-term interest rates have remained extremely low, ranging from 0% to 0.25%, in an attempt to stimulate economic activity and lessen the burden associated with taking out loans. Seven years later, the U.S. economy has stabilized yet the Federal Reserve has preserved low rates.

Steady economic growth and declining unemployment have catalyzed consideration of increased rates. While the Fed’s policy-making committee refrained from raising rates at their two-day meeting in mid-September, it asserted its plans to do so in the near future. Janet Yellen, Chairwoman of the Federal Reserve, stated that the decision to keep rates low was not a quick or unanimous decision. As a result, she gave reasons for both raising and maintaining interest rates, but stated that, “The larger the shortfall of employment or inflation from their respective objectives, and the slower the projected progress toward those objectives, the longer the current target range for the federal funds rate is likely to be maintained.”

Since the unemployment rate reached its peak of 10% in 2010, it has declined to a rate of 5.1% in August 2015 and remained there last month, with only 142,000 jobs added to the economy in September. The natural rate of unemployment—a rate of unemployment caused by structural changes that never completely disappear from an economy—likely sits around that five percent level, which thus indicates that the economy can handle higher interest rates. However, many Fed members view economic growth as unfinished. Last month’s 1.5% inflation rate was lower than the Fed’s goal of 2%. The labor market’s ability to withstand growth without noticeable inflationary indications, which undermines the Phillip’s Curve, supports the Fed’s reasoning behind maintaining low interest rates at the moment. That reasoning is due to the idea that if unemployment continues to fall, theoretically, inflation should rise. That being said, the current plan to keep interest rates low while unemployment continues to fall also possesses a high chance to backfire, as the Fed must monitor signs of hyperinflation that could result from such a plan.

The Fed’s hesitation in raising rates also stems from unstable global economies, specifically China and its recent bear market. The Shanghai Composite, China’s largest stock exchange, dropped over 20% by the end of June from its high on the 12th. By raising our interest rates, investing in global markets will generate harsher consequences upon failure to pay back loans, only to be magnified by China’s hurting economy. Accordingly, capital investors will likely flood out of foreign markets and move into less-volatile ones. However, throughout our recession and the proceeding years, China has been an integral part of recovery. Thus, moving away from heavily investing in China predisposes the U.S. to halted or slowed economic growth.

Lower interest rates also often lead to an increase in spending on consumer goods, services, and assets. Likewise, firms have a greater inclination to make capital investments because the rate of return is more likely to exceed the interest rate. This factor is not always beneficial to the economy, though. An emphasis on spending may, at the same time, create a deterrence from saving. With such a low return on savings, individuals and firms tend to spend and invest rather than save. However, many households rely on the interest from their savings as a source of funds, thus, income dislocation results from minimal interest accumulating in their accounts.

Another issue associated with lower interest rates involves financial intermediaries partaking in risky investments because they have the potential to generate higher returns. Similar to the mortgage crisis of 2009, investors may contribute to subprime lending by making speculative loans to those who may not be capable of repaying them, especially with high rates attached.

Clearly, a great discussion still remains on whether or not now is the right time for the Fed to raise interest rates. The ongoing discussion has clearly been unable to pinpoint the key to determining if the United States has “fully recovered” from the Great Recession; however, such a complex question will likely never have a straightforward answer. Consequently, while keeping interest rates low may be in our best interest at the moment, higher, less-accommodating rates are an inevitability in the near future that we must hope the economy is ready for.