Abacus: Interest Rates And The Fed — The Cost Of Recovery

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On Sept. 26, the Federal Reserve Bank increased the federal funds rates to 2.25 percent from 2 percent indicating the Federal Open Market Committee’s belief that the economy has achieved normalization and can require cooling down or at the very least, stabilization. The Fed also dropped a word that had been underpinning many of its statements before: “accommodative.” The word was used to symbolize the Fed’s inclination to accommodate low growth and higher unemployment; dropping the word off its pedestal symbolizes a shift in the Fed’s outlook for the economy.

The federal funds rate is the rate at which depository institutions (i.e. banks) lend reserve balances to other depository institutions overnight. They are what other interest rates (that apply to consumers and businesses) are based on. Thus, incremental hikes mean that these other rates will be increasing too. For some time, this was good news; individuals are bound to earn more interest on their savings and if anything, it is an indication of a well-functioning economy, one that can work without the Fed holding its hand as it has done for many years since 2008. However, increasing rates mean that the rates applying to debt payments, be it mortgages or student loans, are set to increase. If anything, this would dissuade further loan-based purchases and further home purchases. So, what is the Fed thinking?

Through the Fed’s encrypted statements and history, it is possible to see that some of their tightening monetary policy is due to extremely low unemployment. Unemployment is at record lows, at 3.8 percent (lowest since 1969), which is an indication of a tightening labor market. This figure lies below the expected NAIRU, or non-accelerating inflation rate of unemployment, which tends to lie around 4 percent. This creates the question of whether there is a new NAIRU, or if we are running too tight in the labor market; less attractive jobs that provide less security and wages will be forced to make their jobs more attractive. That is not necessarily a bad thing in and of itself, however, the best way to attract workers from a short supply is to bump up the pay. Companies will be forced to follow this trend, thus setting up grounds for upward pressure on inflation, something no one really wants. Rising interest rates, however, can combat this. Employers are less inclined to hire when they have higher out-of-pocket costs from interest rates.

Think about what else interest rates apply to. Some plastic, in your wallet maybe? Your credit card payments will probably be a tad bit higher when the Fed nudges up the federal funds rate. The prime rate tends to be about 3 percentage points above the fed fund rate, so any hike is increased by give or take, that amount. This tends to slow growth by discouraging spending, as the supply of money has become more expensive.

Coming back to mortgages, since these are long-term loans, the federal funds short terms hikes do not have direct impacts straight away. That said, rates are set to hike one more time in 2018, and a few more times through 2019. This means that mortgages do have the chance of becoming more expensive in the years to come.

The federal funds rate had been extremely low since the 2008 Financial Crisis, in hopes of reviving the economy from a deep recession. Incremental hikes were made once data showed that unemployment was a shrinking figure. An article from the New York Times states that individuals hit hardest by the Great Recessions, normally less educated individuals that only have a high school diploma, are gaining employment and joining In this period of economic growth. Usually these individuals tend to be the last to reap the benefits of any positive economic growth, with a general ratio of 1 unemployed college graduate to 3 employed high school (or lower) graduates; the fact that they are joining in the workforce means that after a decade, the labor market is nearing its (highly theoretical) equilibrium point. This sign is good news for us all but seems to beg that the Federal Reserve remain wary of any inflation spirals as the labor market becomes tighter. Certain industries, such as seasonally-based ones are short on labor. Department stores are keen to hire whatever labor they can kind and offer better packages than before to ensure that they are well equipped with employees for the busy holiday season.

Nonetheless, rate hikes should be a nod to a thriving economy. The only advice here is to watch out for exuberance; no one likes bursting bubbles, not even the Fed.