I am delighted to be able to start another season of student guest posts with this guest post by Patrick Goodney. The students in my “Monetary and Financial Theory” class are required to do 3 blog posts each weak during the semester. From among the best of these I choose some to be guest posts here. (You can see the class assignment and resource blog here, and links to student guest posts from previous semesters here.) Patrick’s post below is the first student guest post this semester.
I have a different take on the current monetary policy situation than Patrick, as you can see from my post “Larry Summers: The Fed Looks Set to Make a Dangerous Mistake by Raising Rates this Year,” but I thought Patrick made the case for raising the Fed’s target fed funds rate sooner rather than later as well as anyone else I have seen. This guest post is a good starting point for the debate. Here is Patrick:
Increasing the federal funds rate before the end of the year would increase the Fed’s credibility and would remove some of the harmful speculation on their plans for the future. It would also be a good start to believing we’re finally out of the shadows of the Great Recession.
In June, the Fed projected to “raise the short-term federal-funds rate from near zero now to 1.625% by the end of 2016 and to 2.875% by the end of 2017,” according to The Wall Street Journal. Many were expecting the Fed to take the first step in hiking rates during their mid-September meeting. However, the near-zero rate persisted. The seemingly apprehensive Fed has many wondering: if the Fed is planning on gradually increasing interest rates, when exactly are they going to actually start?
The common thread through recent media reports on the Fed is a lack of confidence in their ability and willingness to effect change. There is some extreme pessimism about the odds of an increase in the federal funds rate this year. Futures market traders put the probability of a federal funds rate increase before the end of the year at just 35%, according to Jon Hilsenrath and Ben Leubsdorf of The Wall Street Journal. There is some extreme pessimism that an increase now would be good for the economy. Many say that the economy still needs the support of a near-zero interest rate. And there is even pessimism that the Fed isn’t actually able to change the federal funds rate at all.
Matt Phillips argues in Quartz that the Fed’s ability to impact the federal funds rate is uncertain, saying that “in the near decade since [the last time the Fed increased interest rates], pretty much every rule, technique, and guideline the Fed once relied on has been drastically rewritten, revamped, or removed.” Phillips says that the Fed would be working with an entirely new toolbox when it comes to increasing interest rates, and that any outcome resulting from using this toolbox is part of “the greatest monetary experiment in history.”
So there exists significant doubt about the Fed’s power in general, to say the least. The low federal funds rate has persisted so long many are taking it for granted. And the economy is continuing to perform very well—The Wall Street Journal reported yesterday that “The nation’s gross domestic product, the broadest measure of economic output, revved up to a 3.9% seasonally adjusted annual growth rate in the second quarter.” The continued success of the economy is some of the reason why the Fed is planning on increasing rates. The Fed’s policies come with a lag—“If it waits too long, [Federal Reserve Chairwoman] Yellen said, the Fed might end up having to raise rates abruptly to stop the economy from overheating,” write Hilsenrath and Leubsdorf. So surely some change in the interest rate will be inevitable.
One reason why this increase in the federal funds rate should happen sooner rather than later is because, frankly, the Fed needs to show some signs of life in order to gain some credibility and to also prevent speculative forces that lead to “inappropriate risk-taking that might undermine financial stability,” using some more words from Chairwoman Yellen.
The announcement of an increase before the end of the year would be a signal to consumers that we are finally okay again and is a first step to getting the Fed on the path they’re heading towards anyways. The Fed has been taking lashes that they’re unable to change anything, and by announcing that they’re at least going to try, before many are expecting them to, they’ll clear out a lot of the associated negative conceptions about the market. It would be a boon to consumer confidence if there are reports of the Fed believing we do not need the support of a low federal funds rate anymore (perhaps partially mitigating the contractionary effects of the rate hike). The Fed would get more respect as an entity—or maybe less disrespect—by surprising the market with a relatively dynamic decision on their end. And hopefully we would get bogged down by less thinkpieces about how the Fed can’t do anything at all anymore (although that would be unlikely).
So, Fed, silence the critics and let the media write about how America’s finally bounced back, because even if the Fed doesn’t fully believe that to be true, saying it will make it closer to a reality than living in between.