Interest rates are once again making headlines. However, unlike the past decade, the headlines are now focused on the pace at which interest rates may increase rather than decreasing. This monetary about-face from maintaining a very low and accommodative interest rate policy to a gradual and data-dependent increase in interest rates may test the ability of the Federal Reserve to manage the US economy.
The Fed faces several challenges. The first is how quickly to “normalize” short-term interest rates by increasing the official target for the Federal Funds Rate. So far, the Fed has increased its rate target three times (December 2015, December 2016, and March 2017), bringing the official target to between 0.75% and 1.00% from near zero. The consensus appears to be that the Fed will increase interest rates two or three more times in 2017, on its way to an end target of between 2.75% and 3.00% assuming economic data remains stable.
This process seems easy on the surface but there are a number of factors at work which complicate things. The first is that it can take between nine and eighteen months for the full impact of a change in interest rate policy to be reflected in economic data. Therefore, in a way the Fed is “flying blind” as they attempt to make course corrections with limited information about the impact of previous course corrections. Adding to the challenge is the counter-intuitive behaviors that can result from an increase in interest rates. For example, when interest rates begin to increase, consumers and businesses at first may respond by rushing to borrow before interest rates increase further. This can result in an increase in economic activity over the short-term. However, as interest rates continue to increase, the economy can reach a tipping point where borrowing drops off quickly as the higher rates make some purchases unaffordable and some business investment unprofitable. There is no way for the Fed to know where that tipping point is until economic activity has already slowed sharply.
The Fed also has to think about policy options down the road. Should the Fed move too slowly, they may not be able to normalize rates before the next recession, reducing future policy options and flexibility. On the other hand, should the Fed move too quickly, they could force the economy into a recession prematurely.
In addition, this interest rate tightening cycle is different from those of the past because the Fed greatly expanded its balance sheet during the past recession. This means the Fed is holding trillions of dollars in US government bonds and government-backed mortgage bonds. If the Fed seeks to truly normalize interest rates, at some point it will need to sell these bonds. Interest rates are the price of money. The greater the demand for money (the larger the number of bonds) for a given level of supply (investors who are willing to hold bonds), the higher interest rates will be. The problem lies in investor behavior. Since the Fed is a public agency of the US government, it may be forced to announce its intention to sell bonds. This would not only increase the supply of bonds for sale but it may also decrease demand as investors shy away from buying bonds due to fear that interest rates will rise and bond values will decline. In this case, the very act of attempting to sell bonds could result in a lack of buyers and a larger than intended increase in longer-term interest rates. This process has never been tested, at least not on the current scale, making the outcome uncertain.
No matter how one looks at it, the Fed has a tough job ahead of itself in the coming months and years. Whether we like it or not, the US economy will be highly affected by their actions. So as the Fed is to some extent “flying blind,” we are all in the back of the plane hoping they are able to negotiate a soft landing.