Why the Federal Reserve Didn’t Raise Interest Rates

Federal Reserve Didn’t Raise Interest RatesOnce again, the Federal Reserve opted to keep interest rates at historic lows in what I can only characterize as a gross miscalculation. Well-known economists like Larry Summers and Paul Krugman have publicly voiced opposition to an interest rate hike, and it seems like America’s central bank paid attention. (Source: Federal Reserve, September 17, 2015.)

I’m not saying that Krugman or Summers are powerful enough to single-handedly sway the Federal Reserve’s Open Markets Committee. But their reasoning represents the best economic argument in favour of low interest rates.

Unlike other branches of government (I’m looking at you Congress), the Federal Reserve only hires experts. To sit on the FOMC means you are a talented and successful economist familiar with the arguments surrounding inflation and central banking.

The battle over monetary policy ideas isn’t new. And people generally fall into one of two camps. Krugman, Summers, and Yellen are known as “doves,” while people in favour of a rate hike are “hawks.”

Here’s where both sides stand on the issue.

Yellen and the Birds

All central banks have a mandate to control inflation. Their job, above all else, is to keep inflation within a reasonable limit (usually between zero and two percent). But since inflation is a symptom of the broader economy, executing that mandate means the Fed has to soften the downside of a business cycle.

The tools they use are the interest rate and the money supply. When the economy slows down, inflation risks fall below the zero percent floor. Doves say the central bank should lower interest rates to stimulate the economy. By reducing the cost of borrowing money, we can effectively entice people and companies into spending more.

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Sure, the money is borrowed, but spending increases demand, and companies must boost production to meet that demand. That would mean hiring new workers or investing in better technology, creating wages or revenue that will also cycle back into the economy.

A virtuous cycle can come from dropping the interest rate and printing some money. That’s the general position of the doves.

Hawks take a slightly dimmer view of monetary policy. Most of them are acolytes of Milton Friedman, the famous economist who co-wrote A Monetary History of the United States.

In a nutshell, hawks believe that printing more money and cheapening access to credit is market distortion. It debases the value of the currency and, sooner or later, people will flee the currency out of fear it will no longer retain its value.

Krugman Contradicts Himself on Rate Hike

Under normal circumstances, I agree with the doves. In fact, until a few months ago I was still on the easy money bandwagon. First-quarter growth numbers were pretty dismal and there was a genuine risk in raising interest rates when the numbers looked that weak.

Stock markets would panic at the withdrawal of easy money. The S&P and Dow Jones would crash, pushing many firms over the brink of insolvency. At least that’s the worry.

But the revision to first-quarter growth numbers showed things actually weren’t that bad. Since then, we’ve seen steady improvement and unemployment is continuously dropping. I started thinking markets would survive a rising interest rate environment.

Fed policymakers kept dropping hints that a rate hike was coming in September. They pumped expectations until markets were curiously OK with the idea.

And that gets us to a third tool of monetary policy that rarely gets talked about: expectations management.

A big part of central banking is providing guidance to capital markets. Investors like to plan ahead; they want to know where interest rates will be in the years ahead. The Fed sold an interest rate hike as a positive indicator of economic health.

They said it would signal a strong U.S. economy, but then they didn’t do it. Does that mean the economy is weak? That’s the question on everyone’s mind.

Markets crossed a threshold in what they expect from a rate rise, mainly because we no longer have any issues over the supply of capital. At this point, keeping credit cheap is less important that convincing people it’s safe to spend their money.

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