“Small Change” by John Edward
John Edward, who teaches economics at Bentley and UMass Lowell, frequently contributes columns on economic issues.
The possibility of an interest rate hike by the Federal Reserve seems to instill fear. It certainly has Wall Street on edge.
How much impact will Fed action have on the economy? Not much at all.
The question has never been will the Federal Open Market Committee (FOMC) raise interest rates. The question is when. Statements made by Federal Reserve Chair Janet Yellen in September indicated it would likely be before the end of the year. More recent economic data may make them wait until 2016.
The Fed should take action soon. The fear of a small change in rates is overblown.
Economic decision makers respond to changes. However, if the change is small, the response is often minimal or non-existent. If a change is very small people may not even notice.
The last time the FOMC started raising their target for the Federal Funds Rate was June of 2004. At that time the rate was 1.25%. They raised the target to 1.50%. Over the next two years they raised the target by 0.25% every time they met. It took two years to increase the target to 5.25%.
In a recent The Boston Globe article Federal Reserve Bank of Boston President Eric Rosengren is cited as indicating “the Fed is likely to raise rates at a slower pace than in previous expansions.” Yellen and other Fed officials have stated consistently that the Fed will hike rates at a gradual pace. Further, the increases will continue only if new economic data confirms the wisdom of raising interest rates.
The current target for the Federal Funds Rate is a range between zero and 0.25%. When the FOMC does announce a change, the highest they are likely to go is 0.50%.
The Fed has been wise to avoid raising rates too soon. The European Union Central Bank made that mistake in 2011. As a result, their economy suffered and they had to reverse course and adopt the Federal Reserve’s aggressive stance.
New economic data may change things, but the time for patience is probably over. Stock market investors sense that. As the stock market tends to do, it overreacts.
Despite any initial over-reaction, the stock market will be fine if the economy is fine. When the Fed raises rates it will be a sign they believe the economy is getting better.
Small changes in interest rates should not have much immediate effect on the economy. Investors willing to borrow money at current rates are unlikely to be discouraged by rates going up by a quarter of a percentage point. In fact, they may be encouraged to borrow before rates go up even more.
Under normal conditions the Fed raises interest rates to slow down the economy. Not to slam on the brakes; certainly not to put the economy in reverse. Instead they are taking their foot off the accelerator to avoid going too fast. A car driver may do that to avoid a speeding ticket. The Fed is trying to avoid an inflation penalty – prices rising too fast.
Conditions are not normal right now. Interest rates near zero are very much abnormal. It is a sign the Fed does not believe the economy is strong enough to coast on its own.
The Fed started lowering rates in September of 2007. It was a sign they were worried. They aggressively slashed rates in 2008 in response to the Great Recession. They were flooring the gas pedal.
Under current conditions the Fed will just be easing up a little on the gas pedal. By easing up gradually they will be better prepared if the time comes when applying the brakes is necessary. It also gives them the ability to accelerate if they need to. Once they raise interest rates, the Fed can then lower rates if the economy exhibits signs of weakness.
One reason to raise interest rates is to begin a return to normalcy. A gradual increase in the Federal Funds target over two or more years would be a good sign that the economy is growing well on its own – without the Fed having the gas pedal to the floor.
Another reason to raise rates is to help long-suffering savers. Anyone trying to live off their savings is severely hurt by historically low interest rates.
Social Security recipients will not get a cost of living increase next year – the third time this decade. People retired expecting to get by on social security and interest. Many were wrong. To avoid running out of money some have assumed too much investment risk. Others have been forced to go back to work.
Interest rates are an important factor in our economy. The Fed will change interest rates in small increments of 0.25%. The economy will have time to adapt. Much like if you need to lose 50 pounds do not shed all the weight at once. Losing one pound a week is a healthier choice. Your body will have time to adapt.
In a speech given in Boston on the Great Recession and central bank policy, former Fed Chair Ben Bernanke said: “for central banks with policy rates near the zero lower bound, influencing the public’s expectations about future policy actions became a critical tool.” The Fed has done what they can to set expectations. Now people just need to listen – don’t fret the small stuff.