If it were done when 'tis done, then 'twere well it were done slowly. That is official Federal Reserve Board going-forward policy. The announcement of the Fed's first interest rate increase in almost a decade, an upward move of 0.25 percent from near zero, says, and twice, that future increases will be "gradual". That was chairwoman Janet Yellen's main message – abrupt is bad, "gradual adjustment in the stance of monetary policy" is the way to go to avoid past central bank errors by waiting so long that it has to jack rates up abruptly, throwing the economy back into recession. The mid-range forecast of Fed policymakers is that the federal funds rate – an important tool in the Fed's policy kit – will rise to 1.375 percent at the end of 2016, 2.375 percent at year-end 2017, 3.25 percent at the end of 2018, and then to 3.5 percent for the longer term.
Don't be fooled by the neatness and apparent precision of all of this. The real world is messier than that, as Yellen well knows. After all, in 2006 as a member of the Fed's monetary policy committee she voted to raise rates to head off "incipient inflation", and now is proposing to lower them at a time when she is hoping the inflation rate will rise. How a rate move that contained inflation in 2006 can induce it in 2015 is not explained, perhaps because the chairwoman is following the advice Bagehot once offered in another context, "We must not let in daylight upon magic."
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Yellen warns that future increases will depend on how the markets and the economy react to this latest one:
-whether increases in the fed funds rate will take long-term rates up with them, or a flood of incoming dollars from nervous investors around the world will drive the price of Treasuries up, and their yield down,
-whether the economy does indeed grow at the Fed's predicted annual rate of 2.4 percent, faster than it has been able to do during the current recovery,
-whether remaining "cyclical weakness" can be overcome and "shocks" avoided,
-whether the current nil annual inflation rate rises to the Fed's 2 percent target,
-whether emerging economies successfully navigate past both the Scylla of recession, looming before those that follow the Fed and raise rates, and the Charybdis of a depreciating currency and consequent capital flight if they decide not to match the Fed's move.
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You get the idea. Certainty is not a gift that Yellen and her colleagues are likely to find in their Christmas stockings. Yellen admits that theories underlying economic forecasts "are not perfect". As well she should. The forecasting models used by the Fed have "missed their targets by large amounts … [and have] not worked out empirically over the past five years," according to former Fed Governor Larry Lindsey. So it might not be a bad thing that policy is "We'll see", as it has been dubbed by another former governor, Richard Fisher, who recently stepped down as head of the Federal Reserve Bank of Dallas. Fisher goes on to liken Fed policy to that of the long-time leader of China, Deng Xiaoping, who suggested crossing a river by feeling the stones under your feet rather than guessing at its depth.
The Fed's policy team believes that the U.S. "economy is on a path of sustainable improvement … [and is] confident about the fundamentals driving the US economy." The labor market, to which Yellen pays considerable attention because of her strong views on the terrible social effects of unemployment on families and workers, 'has improved further." The unemployment rate is at 5 percent, half its recession peak, with the Fed contending that its monetary easing accounted for 1.75 percentage points of the decline. The broader measure of unemployment, which includes discouraged workers and those involuntarily working part time, is also down, to 9.9 percent from a peak of 17.1 percent. True, the labor force participation rate is lower than the Fed would like it to be, and "some cyclical weakness likely remains", but if not now, when would rates be raised? Besides, it would be difficult for the Fed to be regarded as a credible policy maker if it suddenly refused to consummate its long and much-trumpeted dalliance with rising interest rates.
So up they went, ignoring critics who contend that the Fed's rosy outlook is simply wrong. The manufacturing sector is not doing well; the level of new home building, although picking up, "remains low" (Yellen's description); wages have not responded to the tighter labour market; inflation-adjusted after-tax incomes in this recovery have grown at an annual rate of only 1.8 percent, far below the 3.3 percent average of the last three expansions according to the Wall Street Journal; the very strong auto sector is heavily dependent on low interest rates and lenders' attitude to credit quality that is reminiscent of the one held by mortgage lenders before the financial crisis; the word "bubble" is being heard by developers of commercial real estate. The widely respected Larry Summers, Harvard economist and former Treasury Secretary, has been arguing in a series of op eds, "The case for hitting the brakes in an economy with sub-target inflation, employment and output is not there -- regardless of whether the brakes are going to be pressed hard or softly, singly or multiple times." Billionaire investor and shareholder activist Sam Zell goes further. He told Bloomberg's GO TV that there is a high probability of a recession in the next twelve months, that deflation looms, that asset prices are headed down, and that Dodd-Frank has reduced liquidity, something of which holders of junk bonds were recently reminded to their horror and cost. All of which would suggest (1) that raising interest rates just now is not a very good idea, unless (2) salvaging Fed credibility is an over-riding consideration.
The central banks of several well-run advanced economies – Chile, Israel, Australia, Sweden, Canada, New Zealand, Norway and South Korea – have been forced to reverse course after raising rates, as was the European Central Bank. Yellen would not like to add the U.S. to that list, especially since that would be taken by those clamouring to rein in the Fed's independence more as evidence of ineptitude than of a flexible, data-driven response to events.
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The game of who wins, who loses, is underway. Wells Fargo, America's fourth largest bank, immediately announced that it would raise the rate it charges its most credit-worthy borrowers from 3.25 percent to 3.5 percent, a move immediately followed by most other banks. The banks, says one analyst, have borrowers "dangling over the sword of Damocles", a position that could prove less life-threatening than under the sword but a bad place to be nevertheless. The banks will not immediately raise the rates they pay depositors, and then not by the full amount of their higher charges to borrowers. Erika Najarian, of BofA Merrill Lynch Global Research reports that in 2006 banks passed along 17 percent of the increase in rates to depositors over the next year, but expects changes in regulations to up that to 30% this time around. Still, banks win, borrowers lose, savers wait for a small slice of the pie Yellen has put on bankers' plates.
The interest rate rise is what we call in boxing, and lately in the set-up of Republican debates, the undercard, the preliminary before the main event. Zero interest rates were not the only weapon the Fed deployed against the recession. It also engaged in a massive bond-buying programme – QE1, 2 and 3 – that pumped $2.5 trillion into the economy according to a study by Marc Labonte for the Congressional Research Service. Not until "normalisation of the level of the federal funds rate is well under way" and its effects are clear, says Yellen, will the Fed begin to shrink its balance sheet. That chore is for another day, or more likely another year.