March 22, 2015
The Rate Hike Calculus
There is much speculation over the timing of the Federal Reserve’s decision to raise interest rates. One common approach by Fed watchers is to parse every word and statement to divine the moment rates will rise. Another is to understand the economic models the Fed is using to guide policy. As an economist, I obviously prefer the latter approach, and so here’s my explanation of the models.
First, all things being equal, any increase in interest rates will slow economic growth. Interest rates are the price of borrowing for capital investment, and the law of demand will be obeyed. Higher borrowing prices means less investment, lower employment growth and other unwanted side effects. No one wants this to occur, but the alternative is inflation, which will reduce investment over the long run.
The Federal Reserve has a large group of very good macroeconomists. The models they construct vary from region to region, but all have some common elements. Each one models financial markets such as stocks, bank lending and bonds. They each measure markets for household consumption of durable and non-durable goods. They also examine labor markets.
It is worth noting that all these models may be described as new-Keynesian because they all rely upon well-documented human market behavior along with slow and variable adjustment rates in labor markets. Because of this, the Federal Reserve may influence short-run economic activity by varying interest rates, and hence the cost of borrowing.
Today, the U.S. economy is in the midst of a very tepid recovery. Overall, growth rates are unusually slow, home building remains at historically low rates, large numbers of workers have exited the formal labor force, and governmental debt layers an implicit brake over the long-term prognosis for growth. So, Fed decision makers want to squeeze as much growth out of the economy as they can before raising rates.
The models say that we can wait some time to raise rates before inflation begins. This is partly due to lower energy costs, partly due to weakening world economic conditions, and partly because labor markets are worse than the unemployment rate suggests. So, from a purely labor market perspective, interest rate increases may not happen this year. The market for goods is less important to the decision, but financial market models tell a concerning story.
Interest rates have been so low for so long that an increase in Federal Reserve rates or an unanticipated spike in inflation could lead to a dumping of U.S. Treasury Bonds and a large spike in U.S. dollar valuation. This would pummel the housing market and weaken exports. However, we have no historical examples of this to calibrate the models, so count on the Fed to weigh this in to its timing calculus. The longer it delays, the stronger the Fed views financial markets and the weaker it views labor markets. An early rate hike signals the opposite worry. The Fed will be looking at both issues closely over the coming months.
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