We know it will happen, but when? America’s central bank, the Federal Reserve (Fed), has been hinting for months that they are about to raise the benchmark federal funds rate. After the 2008 financial crisis this rate was slashed to near zero to help the US economy rebuild, and near zero is where it has stayed since then. However, the decision to raise or not to raise interest rates is not an easy one. Predicting the forward growth and strength of the US economy, the level of inflation, and reduction in unemployment, while monitoring similar economic indicators across the other major global economies is difficult. At the same time to give enough headroom to be able to reduce rates in the event the Federal Reserve need to stimulate the economy in the future is a balancing act. The right decision relies on accurate data both current and predictive.
The federal funds rate is the interest rate that one bank charges another bank to keep funds at the Federal Reserve overnight. The Federal Reserve can increase this rate in an attempt to slow down the economy and control inflation. The fact that policymakers are considering raising the interest rate means that they are confident with the growth of the US economy and expect it to keep improving.
There are many different opinions as to when and why the federal funds rate should be raised. Some believe it should have been raised already, while others feel policy makers should wait until December, or even early 2016, to allow inflation to rise. There are valid arguments for raising rates now versus holding off.
Reasons for raising the rate in September:
- Maintaining control over a growing economy. As the economy continues to strengthen, low interest rates could lead to excess demand and high inflation, which would negatively impact the economy.
- Creating a safety net in case another recession occurs. Since the rate is so low to begin with, there is no room to cut interest rates if the economy needs a boost, should the US find themselves in another recession.
- The job market is improving. The job market has been holding back the US economy and deterring this rate hike, but with 215,000 jobs added in July alone, is this enough proof to solidify the need for an increase.
Reasons for holding off on raising the rate:
- The US doesn’t have enough inflation yet. Inflation has not yet risen beyond the Fed’s target of 2% in years, and policy makers want more evidence that it will rise before ordering a rate increase.
- Wages are not rising. Although the job market is improving, wage increases are only slowly following, which could potentially result in not enough disposable income in the economy to handle higher interest rates.
- Rates are low worldwide. China recently devalued their currency, and Europe is dealing with Greece’s massive debt. If the US raises interest rates while the rest of the world is keeping them low, US imports and exports to other countries could suffer.
As the federal funds rate affects many conditions, the timing of such a decision is critical. Raising the rate too early could stall the growth of the economy, potentially leading to another recession. However, delaying the hike could lead to inflation becoming too high to be able to control. As data provides information; information creates knowledge; and knowledge allows decisions to be taken – bad data results in bad decisions. The impact of the decision the federal officials decide to take when they convene in September will rely on the accuracy of the economic data they use. Only future economic data will tell them whether they took the right decision.