The Fed’s Rationale for Raising Rates

  • The Fed’s Rationale for Raising Rates
As recently as a week and a half ago, we were comfortable with our prediction that the Federal Reserve would wait until the middle of the year to take the next step in normalizing U.S. monetary policy. There seemed to be no immediate prospect of an increase, and the Fed has been exceptionally cautious over the past few years.

But since the beginning of March, a remarkably well-orchestrated string of Fed speakers has made it clear that there will be an interest rate increase on March 15. Because it occurred during a slow period in the economic calendar, this change of tone was not based on new data. So what prompted the increased urgency?

In our view, there are two main reasons. First, asset prices have risen into territory that might cause concerns about financial stability. And secondly, the Fed was deterred from acting several times last year because of international uncertainties. Today, we are in a period of relative calm, but upcoming events in Europe threaten to disrupt the peace. The central bank seems to want to take advantage of this window of opportunity.

Here is our take on the likely content of next week’s conversations.

Much of today’s discussion surrounding business activity centers on “animal spirits.” Economic actors seem to be upbeat about the quarters ahead; if they act on this impression, it can become self-fulfilling.

History suggests, however, that confidence readings do not always presage movements in broad economic trends. And if the sources of optimism are ultimately not realized, spirits might sink. Our forecast for growth of around 2% after adjusting inflation, which matches the Fed’s most recent projections, does not create a sense of urgency for monetary policy.

Progress on the administration’s economic agenda has been slow. For procedural reasons, attention has turned first to reform or repeal of the Affordable Care Act (ACA). This has proven to be far more complicated than some had thought; few Republicans want to sustain much of the current system, but none want to be responsible for dismissing 20 million Americans from the insurance rolls. An alternative to the ACA was finally proposed this week, but has not yet met with broad support.

Getting reforms in place may become even more challenging. Deficit hawks will not want to see the budget deficit expand much, if at all. But paying for proposed tax cuts and infrastructure spending cannot be achieved merely with reductions in discretionary federal spending. (There isn’t much left to cut, see here.) The “border tax” has the potential to raise a lot of revenue, but also create a lot of economic disruption.

Reality may force delays in passing pro-growth legislation and diminish its size. The up-side risk to U.S. economic growth and inflation may not be as large as some might think.

The February employment report showed widespread gains in hiring, with both goods and service sectors accounting for the overall increase. The 3-month average of payrolls at 209,000 is more than adequate to hold the jobless rate steady. Although hourly earnings regained strength, employment compensation is mostly stable and awaiting additional acceleration at the late stage of the expansion.