ALL across America there are nine-year-olds filing into fourth-grade classrooms who have yet to enjoy the thrill of a Federal-Reserve rate increase. The Fed, America's central bank, last raised rates in June of 2006, by 25 basis points to 5.25%. It soon found itself reversing course, as a housing bust gave way to the Great Recession; since December of 2008, the Fed's benchmark interest rate has been set at between 0.0% and 0.25%. Yet that may be about to change. A speech delivered on August 29th by Stanley Fischer (pictured), the vice-chairman of the Federal Reserve, gave no indication that the Fed had been deterred by recent market wobbles from its plan to raise rates this year, and perhaps at the next meeting, on September 16-17th. Why is the Fed about to raise interest rates?
The Federal Reserve is charged with setting monetary policy in order to meet Congressionally set mandates for "maximum employment" and "stable prices". The Fed has long determined that the best way to meet those mandates is to target a rate of inflation of around 2%; in 2011 it officially adopted a 2% annual increase in the price index for personal consumption expenditures (often called PCE inflation) as the target. Fed officials reckon that when the economy is weak, inflation will fall, while when the economy is close to maximum employment, rising wages will push up inflation. Keeping inflation near 2% should therefore keep the economy growing at a healthy clip. The Fed raises its benchmark interest rate (called the federal funds rate) when the economy is growing too fast; that encourages people to spend less and save more, which slows the economy down and reduces inflationary pressure. When the economy is growing too slowly, it reduces the fed funds rate. Since 2008, when its benchmark rate fell to near zero and could not be cut any more, the Fed has instead sought to encourage investment and spending by other means, like purchases of government bonds designed to reduce long-run interest rates.
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The Fed now believes that the time for those unusual measures is over, and that it is appropriate to begin raising rates. The improved financial heath of households and banks, seven years after the financial crisis, mean that slightly higher rates should not cause too much pain. Its preferred inflation gauge, PCE inflation, is still well below the 2% target; in the year to July it rose just 0.3%, or just 1.2% if volatile food and energy components are excluded. But America's job market has been booming. Employers added nearly 3m workers over the last 12 months, and the unemployment rate, at 5.3%, is close to levels at which Fed officials expect wage increases to accelerate. Fedsters argue that inflation has recently been held down by one-off factors, such as falling oil prices and a rising dollar, the effects of which should soon fade. They also note that low interest rates can encourage risky investments that lay the foundation for future financial havoc, and they worry that if inflation is allowed to shoot above 2% people may lose confidence in the Fed's ability to keep price increases under control, which could lead to still higher and more volatile inflation rates. The Fed is therefore expected to increase rates once or twice before the end of the year: perhaps to 0.25% in September and 0.5% in December.
Yet raising rates is risky. Despite low unemployment, wage growth has so far been modest. That suggests that wage-driven inflation may yet be some way off—and America's labour market may still be some way away from "maximum employment". The Fed has been over-optimistic about inflation before; it found itself repeatedly restarting its asset-purchase programmes after inflation failed to rise to and stay near target when purchases were curtailed. The move toward Fed tightening has also destabilised global markets, squeezing emerging economies, putting downward pressure on commodity prices and pushing up the dollar; rate rises may therefore ensure that the factors which have been dragging down inflation are not in fact one-off events. But what really ought to give the Fed pause is the asymmetry of the risks it faces. If it waits too long to raise rates then inflation could rise to 3% or 4%. But inflation which temporarily rises that high is not a major threat to the American economy, and the Fed has unlimited capacity to raise rates to rein in price increases. If it hikes too soon, however, then very low inflation might quickly become deflation, and the Fed will have little room to cut interest rates before returning to zero—and the uncertain world of unconventional monetary policy. It is understandable that Fed officials want to get back to interest-rate business as usual. If they move too soon, they may not get to enjoy business as usual for very long.
