The Federal Reserve Bank https://www.flickr.com/photos/federalreserve/12288573173/in/photolist-jHU9Fg-dRaAqt-nLHXoJ-zEcDEt-kJWKDB-oYZ8Z9-nFaERV-Bh2bL3-qLuAJv-tkaLFq-e8VdUS-beRm96-f1ufGj-oboTWu-naZHb1-nvMqhY-mUPvii-8o2P6o-nswxJw-nqrAYm-nLTDrp-n3aQ3R-nJGRD7-odqTQa-ebXLT1-mZVAX2-ebXKxf-5wfKBb-ebS7Fr-mdSD2N-nswwx3-ebXLUG-nUauQM-ebS7FH-Ar7RJY-ssBomA-kecf3F-mdSTfs-suUtEe-pLj1Rx-o9BCxG-f1ufRA-AqNbVQ-nswwxU-ebS6oa-ebXKyh-qp8h5f-qrMHGN-qrFmQD-ebS6op

The 2015 Year Award for most Suspenseful Topic in Economics really just has one candidate: the Federal Reserve’s interest rate decision. Last time the FED raised its benchmark interest rate no one had an iPhone, Obama was just a Senator and most of all, the financial crisis had not yet happened. But this year, as the US economy continued to recover, a move away from the zero lower bound at last became a possibility. As the likelihood of an interest rate rise by the FED grew, the debate about what the FED should and would do intensified, and everyone got involved. The IMF and Bank for International Settlements urged the FED not to, while Bloomberg and the OECD argued in favour. This article seeks to explain the FED’s situation and why there has been so much debate.

Before we look at the decision the FED faces, it helps to clarify what its objectives and tools are. The FED has a so called dual mandate: two objectives that guide its policy. These objectives are keeping prices stable and unemployment low. In quantitative terms, this translates to keeping inflation around 2% and the unemployment rate somewhere between 4.7% and 5.8%. What is crucial to understanding the dual mandate is the underlying theory that links both objectives. Economic theory suggests there exists a trade-off between inflation and unemployment; the well-known Phillips-curve. Intuitively, as the economy grows demand for labour rises and unemployment decreases. Since the supply of labour is essentially fixed, falling unemployment eventually causes the labour market to tighten and wages to rise. Higher wages in turn lead to higher product prices, or in other words inflation. The unemployment rate below which this starts to happen is called the natural rate of unemployment[1].The natural rate of unemployment is a theoretical concept, which means we do not directly observe it but can only model and estimate it. The Federal Reserve believes the current US natural rate of unemployment to be close to 5%. This explains the reasoning behind the targeted unemployment rate: keeping unemployment around 5% is in line with price stability (in technical terms: non-accelerating inflation). The reasoning behind the 2% inflation target is less “scientific” and more subjective.

The FED’s primary policy instrument is the Federal Funds Rate. The Federal Funds Rate is strictly speaking the interest rate at which depository institutions lend their reserves to other depository institutions overnight. In general it serves as a benchmark interest rate for the entire US economy. All other interest rates: on loans, credit cards, mortgages etc., are in the end based on the Federal Funds Rate, which makes it one of the key variables of the economy. For simplicity, I will refer to the Federal Funds Rate as the FED’s interest rate.

The above is a simplified introduction to the FED’s decision making. Now let’s look at data on the US economy. Over the past years, the unemployment rate (independent of what definition is used) has steadily fallen and currently lies around 5%, close to its natural rate. The level of inflation in the US depends largely on which measure of inflation is used. Without going into details, here I will look at the same measure as the one preferred by the FED, namely Personal Consumption Expenditure inflation (PCE). For 2015 PCE inflation is estimated at 1.6%, roughly the same as in 2014 and somewhat higher than in 2013. From this short analysis it seems fair to conclude an interest rate rise is appropriate: the unemployment rate is close to its natural level and if it falls further inflation is likely be pushed past the 2% target. If the FED would increase the interest rate, it would slow down the economy, stop unemployment from further decreasing and keep inflation at bay. So where is the debate coming from?

There are several issues that complicate the FED’s decision and have caused opinions to diverge. Firstly, the link between unemployment and inflation appears to be broken. The key mechanism that links these two is wage growth. But while unemployment has fallen, US wage growth has seen very little change: nominal wage growth has been flat since 2009 while in the meantime the unemployment rate has fallen by half. This “wage growth puzzle” is central to the debate on the FED’s policy. Why should the FED already rein in economic growth when the working people in the economy have not yet reaped any benefits from it?

Secondly, there is the bigger picture of the global economy. Outside of the US borders, the world economy looks less rosy. Falling Chinese demand, turmoil in emerging markets and sluggish commodity prices are just some of the issues already plaguing the global economy. A higher interest rate in the US would only further hamper global growth. The US plays a pivotal role in the global financial markets and a higher interest there will recoil across global markets. Debt levels around the world are high and higher global interest rates will only drive up the costs of serving this debt. This is one of the main reasons the IMF and Bank for International Settlements strongly argued against the FED taking action. Recovery in the rest of the world is simply not firm enough yet to sustain higher interest rates. Furthermore, a higher interest rate will further strengthen the already strong dollar. A stronger dollar will make payments on foreign dollar denominated debt, of which there is around $9 trillion worldwide, even more biting[2]. If a firm earns money in different currency, it first has to convert these revenues to dollars before serving its debt. A stronger dollar makes this conversion more expensive and the burden of the debt more heavy. In short, a higher Federal Funds Rate could be the final push to a new global financial crisis; something the FED is not likely to want on their resume.

Finally, timing is arguably the most crucial aspect of monetary policy. Were the FED to misjudge the state of the economy and raise interest rates too soon it could trigger a new recession. In the past, raising interest rates too soon has had severe effects. When the ECB raised its benchmark interest rate in 2011, it turned out they acted too soon and the Eurozone entered a double-dip recession. The same happened in 2000 when the Central Bank of Japan lifted rates just as the US tech bubble burst: a recession followed. Those that argue the FED should wait claim that the costs of acting too soon (risking a new recession) outweigh the costs of acting too late (possible higher inflation).

 

Amidst these difficulties what is the FED’s expected to do at their next meeting on the 15th of December? At their previous meeting, the FED explicitly named two issues that kept them from raising the interest rate: concerns about the global economy and wanting to wait for further improvements in the labour market. Since then, growth prospects for the global economy have not been further downgraded and wage growth in the US seems to have finally picked up. The data is finally pointing in the same, positive direction. One final thing has to be noted as well. One can argue that the long wait and discussion have all been part of the FED’s plan from the beginning. Since people have now spent so long wondering about the FED’s decision, any action that is finally taken can hardly be seen as a surprise. In this case, markets anticipate the shock and its potential negative (or positive) effects will be limited. Some now estimate the odds of a rate rise this month at 74%. As the opinions of the market converge, action is becoming more likely. This is because the FED takes market expectations into account and does not wish to upset the markets by moving against what they expect. If they were to delay much longer this could become a possibility. At last it seems, the dilemma is solved.

 

[1] Here it should be noted that I do not distinguish between the non-accelerating inflation rate of unemployment (NAIRU) and the natural rate of unemployment. Though there is literature that suggests they should be distinguished, from the perspective of short-run monetary policy (as discussed in this article) I believe this can be ignored.

[2] For more on the implications of US monetary policy on foreign dollar denominated debt see this paper by the Bank of International Settlements.