In a significant moment for monetary policy, Fed Chair Janet Yellen is expected to announce a federal funds rate increase following a two-day meeting of the Federal Open Market Committee. This marks a milestone, as it’s the first time in nearly a decade that the central bank has opted to raise rates.
The timeline since the last rate hike on June 29, 2006, has been eventful. Notably, the release of the first-generation Apple iPhone on June 29, 2007, coincided with this last increment. While the link between tech evolution and monetary policy may be tenuous, it underscores just how long it’s been since we’ve seen rising rates.
The past decade hasn’t been without challenges. The economy has faced significant issues including the Great Recession, the dramatic collapse of Lehman Brothers, the implementation of TARP, mounting budget deficits exceeding a trillion dollars, an expanded Fed balance sheet by over $3 trillion, a prolonged zero interest rate policy, and a national debt growth beyond $10 trillion.
Finally, after much hesitation and introspection, the Fed appears ready to slightly tighten the reins of monetary policy. Should this be a cause for celebration or concern? And does it even matter?
It’s important to recognize that a 0.25 percent increase in the federal funds rate is not a return to normalcy. The Fed will continue its heavy-handed intervention in credit markets and the broader economy, perpetuating existing price distortions and the potential for market instability.
Adjusting the Thermostat
The Fed must begin to raise rates, and a quarter percentage point is a sensible starting point. The question remains: will this be a successful lift-off or just another failed attempt at effective monetary policy?
Reflecting on the previous cycle of rate increases—from June 30, 2004, to June 29, 2006—Fed Chairs Alan Greenspan and Ben Bernanke raised rates 16 consecutive times, with each increment set at a quarter percent, scaling from 1 percent to 5.25 percent. Throughout this period, asset price distortions were rampant.
When Greenspan initiated rate hikes in mid-2004, the housing market was already in the throes of irrational exuberance. In his fixation on inflation and aggregate demand, Greenspan failed to notice the disarray his low interest rate strategy had created in housing prices, leaving him ill-prepared to manage the fallout.
After the dot-com bubble burst, Greenspan slashed the federal funds rate to a historic low of 1 percent, attempting to rejuvenate the market and bolster stock prices. However, the influx of liquidity predominantly found its way into the housing sector instead.
Throughout this period, Greenspan was confident in his methods, treating monetary policy as akin to managing a heating and cooling system. The simplistic approach dictated that the Fed would lower rates to stimulate a cooling economy and raise them to temper an overheating one.
The Fed’s Misaligned Stars
Regrettably, the economy is far more intricate than mere temperature control. The interactions are nonlinear, and the consequences of policy decisions can unfold in unforeseen and complex ways. Rather than effectively smoothing out business cycle fluctuations, the Fed’s approach often exacerbates volatility.
The Fed operates under the belief that artificially lowering the cost of money will boost aggregate demand. The theory posits that cheap credit incentivizes borrowing and spending by consumers and businesses alike, leading to increased consumption, profits, job creation, and economic growth.
After the 2008 financial crisis, the Bernanke-led Fed implemented aggressive strategies that would have horrified Greenspan. They slashed the federal funds rate to near zero and maintained it for seven years, while also injecting $3 trillion into the economy and manipulating interest rates on various treasury instruments.
Despite their extensive efforts, the Fed’s initiatives yielded little success in reviving the economy. Each month and year marked a struggle to understand the sluggish recovery, as policymakers worked to achieve metrics of 5 percent unemployment, 2 percent inflation, and consistent 3 percent GDP growth. Unfortunately, they never quite realized those goals.
Now, Yellen finds herself grappling with a challenging economic landscape. The unemployment rate is low, yet participation in the labor force remains equally subdued. Economic growth is tepid, and trade activity has slowed.
As Yellen prepared for an opportunity to raise rates, the economic conditions shifted, and her window of opportunity may have closed. Nonetheless, having promised action for over a year, she feels compelled to deliver, even if she harbors reservations. The upcoming FOMC statement and accompanying press conference are sure to be eventful.
Sincerely,
MN Gordon
for Economic Prism
