Are We Ready for an Interest Rate Hike?

In her speech Dec. 2, Federal Reserve Chair Janet Yellen foreshadowed a coming rate hike and called it “a day that I expect we all are looking forward to.” That day may come Wednesday, when the Fed decides whether to raise interest rates for the first time since 2006.

What makes the rate hike a day to be hopeful, rather than fearful, is that it demonstrates that the U.S. economy is finally strong enough to return to “normal” monetary policy. The near-zero level of the headline Fed Funds interest rate over the last several years is abnormal because we’ve never had interest rates this low for this long before.

Liftoff, as it’s called, will likely begin Wednesday because the Fed has dropped hints about the unemployment rate and inflation rate it would like to see in order to start raising rates. This refers to the Fed’s dual mandate from Congress to promote maximum employment and stable prices.

Unemployment

In October 2009, the U.S. unemployment rate peaked at 10%—a level that hadn’t been seen since the ’80s. Since then, the economy has regained 13 million jobs, surpassing pre-recession levels. Today, the unemployment rate is just 5%, nearly matching the Fed’s estimate that unemployment should be 4.9% when the economy reaches full employment.

Although the headline unemployment rate looks healthy, other indicators of unemployment could look better. As Yellen acknowledged in her Dec. 2 speech, labor force participation is down, and many part-time workers would prefer to have full-time jobs. Some critics believe that these indicators show that there is still “slack,” or unfilled capacity, in the labor market. But Fed leaders believe that the economy is growing fast enough to fill in that slack in the near term.

Inflation

The Fed wants the economy to have a modest amount of inflation because it encourages growth. That’s why the Fed aims for 2% inflation instead of 0%. But over the last 12 months, the Fed’s preferred measure of inflation has averaged just 0.2% overall and 1.3% excluding food and energy. This low level of inflation is the result of oil price shocks and the strong dollar.

But meeting the inflation goal does not necessarily mean that inflation is 2% today. Rather, the goal is for inflation to reach 2% in the “medium term”—about one or two years from now. This is because monetary policy acts with a lag. Most Fed officials believe there is a tradeoff between low unemployment and low inflation. The Phillips Curve, as this relationship is called, holds that a more competitive labor market causes employers to bid up wages, spurring price hikes as well. The Fed wants to act before this reaction advances too far. Waiting until unemployment drops even further could make it too late to hold back inflation.

As Fed Vice Chair Stanley Fischer put it, “In making our monetary policy decisions, we are interested more in where the U.S. economy is heading than in knowing whence it has come.”

Market Expectations

One of the Fed’s most powerful weapons for guiding monetary policy is the communication of its intent, and it can discern whether markets are getting the message by watching their actions. As Larry Summers pointed out in a column against a September rate hike, over the last two decades the Fed has not raised rates without the futures markets indicating at least a 70% chance of tightening in the next 30 days. This probability is based on 30-day Fed Funds futures contracts, which investors buy to protect against the risk of rising interest rates.

Now, a rate hike seems like a done deal. The probability of a rate hike reached the 70% benchmark following the blockbuster October jobs report on Nov. 6 and has surpassed 80% since the November jobs release on Dec. 4. If the Fed doesn’t move now, it could lose credibility in the eyes of the markets.

The international environment matters, too. Many Fed watchers believed that it would have pulled the trigger in September if not for China’s stock market volatility. Today, many central bankers and finance ministers around the world say that the U.S. should “just do it” and raise rates. The UK is poised to go next—putting these two major economies at cross-purposes with the European Central Bank, which is keeping rates low with quantitative easing.

Trajectory

Looking forward, Yellen and her colleagues have emphasized that even when rates go up, they will rise gradually and top off at a relatively low level. At a November trade association meeting, three private-sector economists predicted three to four rate increases of 25 basis points each during 2016. That means that one year from now, the upper bound for the Fed Funds rate will be about 1% to 1.25%. That’s half the pace of the last rate hike cycle in 2004-2006.

Once rates start to rise, the next great debate is how high they should go. The one thing that most economists can agree on is that the new normal Fed Funds rate will be a lot lower than the 1954–2008 historical average of 5.6%.