Fed Raises Rate for First Time in Almost a Decade

Dec 17, 2015

The Federal Reserve said on Wednesday that it would raise short-term interest rates for the first time since the financial crisis struck, a vote of confidence in the strength of the American economy at a time when much of the rest of the global economy is struggling.

The widely anticipated decision, a milestone in the Fed’s postcrisis stimulus campaign, ends a seven-year period in which the Fed held short-term rates near zero. Even as it raises its benchmark interest rate by 0.25 percentage points, to a range of 0.25 to 0.5 percent, however, the Fed emphasized subsequent increases would come slowly.

The decision to raise rates “recognizes the considerable progress that has been made toward restoring jobs, raising incomes and easing the economic hardships that have been endured by millions of ordinary Americans,” the Fed’s chairwoman, Janet L. Yellen, said at a news conference after the decision was announced.

Interest rates on mortgages and other kinds of loans, and on savings accounts and other kinds of investments, are likely to remain low by historical standards for years to come.

Moving to raise rates is the most important and riskiest decision the Fed has made under the leadership of Ms. Yellen, the Fed’s chairwoman since early 2014.

Every other developed nation that has raised rates since the end of the financial crisis has been forced to backtrack as economic conditions proved unable to handle higher rates. There are also signs of strain in some financial markets as investors dump high-yield junk bonds and pull money from developing markets.

The decision to raise rates was supported by all 10 voting members of the Federal Open Market Committee. They agreed on the move despite concern expressed in recent months by three of those officials that the economy might not be ready for higher rates, a view shared by some outside economists and by Democrats who argue the Fed is prematurely curtailing job and wage growth.

The Fed’s announcement cited the strength of job growth, and the broader backdrop of a moderate-but-steady economic expansion, as evidence that the economy no longer needed quite as much help from ultralow borrowing costs.

Fed officials predicted in a set of forecasts also published Wednesday that they would raise interest rates by about one percentage point a year over the next three years, reaching 3.3 percent by 2019.

The Fed said that beginning on Thursday, it would seek to keep short-term interest rates in its new range. To set the new baseline, the Fed said it would pay banks an interest rate of 0.5 percent on unused money, and it would borrow up to $2 trillion from other financial firms at a rate of 0.25 percent. Those measures were stronger than markets had expected, reflecting the Fed’s determination.

Even as the Fed said it would raise rates, it released a set of updated economic projections from its senior officials underscoring that they expect the economy to grow slowly in coming years. The officials predicted, on average, that the economy would expand by 2.4 percent next year and that the unemployment rate would reach a new low of 4.7 percent.

Most officials predicted the Fed would once again miss its 2 percent inflation target next year.

Ms. Yellen herself posed the question in her statement, “With inflation currently still low, why is the committee raising the federal funds rate target?”

She said that inflation was being suppressed temporarily by factors including lower oil prices and that it would rise as job growth continued. She added that the Fed needed to act now because monetary policy influences economic conditions gradually.

If the Fed waited to raise rates, Ms. Yellen said, “We would end up having to tighten policy relatively abruptly at some point.” She continued, “Such an abrupt tightening could increase the risk of pushing the economy into recession.”

Looking ahead, the rate at which the Fed tightens its monetary reins will be the central question confronting Ms. Yellen and her colleagues as the six-and-a-half-year-old economic expansion unfolds in unpredictable ways. The challenges will be heightened even more by the fact that 2016 is a presidential election year.

The unemployment rate has fallen to 5 percent, a level historically consistent with a healthy economy — and is the primary reason the Fed has decided to act. Inflation, however, remains quite weak, indicating that the economy remains weak, too.

The Fed must also gauge the impact of global weakness on the American economy; the strong dollar appears to be weighing on manufacturing in particular.

Critics of the Fed’s decision argue that the unemployment data is misleading. The share of adults neither working nor looking for work rose sharply during the recession. Those adults are not counted in the unemployment rate, but some may resume looking for work as the economy improves.

“Our job recovery remains incomplete,” Representative John Conyers, a Michigan Democrat, wrote earlier this week. He has introduced legislation instructing the Fed to aim for an unemployment rate of 4 percent, well below the current rate. “The Fed should not slow job creation and wage growth absent clear evidence of inflation,” he said.

Some analysts said they expected problems in the auto market, where cheap loans have spurred booming sales. While housing sales remain well below prerecession levels, car sales have climbed to record heights in recent years. “It will hurt borrowers and it will hurt the real economy because that’s what’s driving the auto industry right now,” said William Spriggs, the chief economist at the A.F.L.-C.I.O.

Still, while rates on mortgages and other kinds of loans tend to rise with the Fed’s benchmark rate, the relationship is not mechanical. During the housing boom, mortgage rates declined even as the Fed raised short-term rates because of increased foreign investment. That pattern could recur if investors once again conclude the United States is a better investment than other parts of the world.

The era of minimal returns on savings also won’t end soon. Berkley Bank in Englewood, Colo., currently offers an interest rate of 0.50 percent on a one-year certificate of deposit. Brandon Berkley, the bank’s president, said the Fed’s rate increases eventually would translate into higher rates for his depositors and borrowers, but he said the bank might not start raising rates immediately.

In raising rates, the Fed is entering an unfamiliar world. Only two members of the Fed’s policy-making committee participated the last time the Fed raised rates, between 2004 and 2006: Jeffrey Lacker, the president of the Federal Reserve Bank of Richmond since 2004, and Ms. Yellen, who was then the president of the Federal Reserve Bank of San Francisco.

Short-term rates climbed in anticipation of the Fed’s announcement in recent weeks, suggesting that investors expect the new system to work. But Alan Blinder, an economist at Princeton University and a former Fed official, cautioned that the Fed’s best-laid plans have rarely unfolded smoothly.

“I never worry about markets underreacting,” he said dryly.

 

[GRAPHIC] Why the Fed Raised Interest Rates

Government borrowing costs will increase as the Fed raises rates

The Federal Reserve decided to raise short-term interest rates for the first time since the financial crisis. Officials said the economy was strong enough to keep growing with a little less help from the central bank. The Fed is likely to raise rates slowly, but borrowing costs already have started to climb. The returns on some investments, like savings accounts, also are likely to increase.

Even as the federal debt grew substantially in recent years, the government’s annual interest payments barely increased thanks to the Fed’s efforts to minimize borrowing costs.

As the Fed raises rates, no borrower will feel the pain more acutely than the federal government, the nation’s largest borrower.

Read more Why the Fed Raised Interest Rates

 

 

Source: New York Times