The U.S. Fed is playing a very long game with interest rate hikes

Though the labour market is returning to normal, the U.S. economy still isn’t firing on all cylinders, so rate hikes will be slow

U.S. Federal Reserve chair Janet Yellen

Federal Reserve chair Janet Yellen at the news conference announcing the U.S.’s first interest-rate hike in nine years on December 16, 2015. (Chip Somodevilla/Getty)

Where were you when the U.S. Federal Reserve announced, at 2 p.m. Washington time on December 16, 2015, that it would raise its benchmark interest rate for the first time in nine years? Some notable obsessives will be able to answer that question if their grandchildren ever ask. In the front row at the press conference, two chairs to the left of the guy from the Wall Street Journal! Normal people have likely already forgotten, if they were paying attention at all. Fed chair Janet Yellen had done such a good job of telegraphing the central bank’s intentions that even Harvard economist Lawrence Summers—the highest profile advocate for leaving America’s benchmark lending rate at zero—stopped trying to sway opinion. It was a day for the history books, but the economic actors of the present had moved on.

One of the arguments for lifting interest rates was that the waiting was hurting confidence. Investors responded to the Fed’s quarter-point increase as if a weight had been lifted. Stock markets rose in North America after the decision. They rose in Asia and they rose in Europe. Some feared the Fed’s increase would trigger an exodus of capital from emerging markets. According to this view, previously adventurous investors would be drawn back to the safety of U.S. debt, now that it promised a yield greater than a pittance. But those who wanted out of places such as Indonesia and Brazil have already left. Some currencies of emerging-market countries rose against the dollar. In Canada, the loonie was weaker, but probably because oil prices slid. Bond yields were a little lower, reflecting the divergent paths for benchmark interest rates in the U.S. and Canada.

So the importance of the Fed’s announcement wasn’t so much the formal shift in policy, but what could be gathered about the state of the world’s largest economy and where borrowing costs are headed. The Federal Open Market Committee, the group of central bankers that sets U.S. interests rates, continued to describe economic growth as “moderate.” The committee’s updated forecasts were essentially unchanged from September. It predicts gross domestic product will expand 2.1% this year and 2.4% in 2016. Officials see the unemployment rate dropping to 4.7% in 2016, lower than the 4.9% rate that Fed associates with its congressional mandate to foster “maximum employment.” Therefore, the Fed likely will need to raise borrowing costs to contain inflation, as a lower jobless rate suggests a tighter labour market that will exert upward pressure on wages. The projections of each of committee member suggest the Fed’s policy rate could rise to 1.5% next year and to 2.5% in 2017.

That’s a gentle climb, a point Yellen emphasized repeatedly at a press conference after the announcement. A growth rate of around 2% doesn’t make anyone’s heart go pitter-pat. Consumer spending and business investment are fine, but factories are struggling because there is so little demand for exports. Yellen acknowledged that a stronger dollar isn’t helping U.S. competitiveness, and a sharp increase in interest rates only would exacerbate that problem. (An index that measures the value of the dollar against the currencies of the U.S. main trading partners had risen almost a full percentage point through Asian and European trading.) The Fed’s tightening cycle likely will be the slowest on record, and Yellen said there will be gaps of undetermined length between each increase.

A Fed populated by disciples of Lawrence Summers could have made a case to leave the benchmark rate at zero. Yellen herself said she continues to think the labour market isn’t as strong as the low unemployment rate suggests, and inflation is well shy of the Fed’s second objective of guiding annual price increases to 2%. Purists of monetary policy tend to counter the low-for-longer crowd with the argument that cheap money will inevitably create asset-price bubbles. Oddly, Yellen avoided using this threat as justification for the increase. Instead, she said the Fed simply wants to make sure it stays ahead of inflation, noting that monetary policy works with a lag. Yellen said she is aiming for a “long-running, sustainable” expansion. If inflation spiked, the Fed would have to raise borrowing costs faster than it thinks the economy can handle. Yellen is trying to avoid that by picking her spots.

A cheeky reporter thought she had cornered Yellen on this point. Earlier in the press conference, the Fed chair said she thought the notion that economic expansions “die of old age” is a “myth.” The cheeky reporter observed that central banks had a track record of killing economic expansions by raising interest rates. Gotcha! Yellen turned the question around: “When you say that central banks kill them, the usual reason that that has been true, when that has been true, is that central banks have been too late to tighten policy and they have allowed inflation to get out of control and at that point they have had to tighten policy very abruptly and very substantially and it’s caused a downturn.”

Bottom line: Janet Yellen wants to try to make up for the weakness of the recovery from the Great Recession by keeping the expansion going for longer than fatalists think is possible. With the labour market essentially back to normal, inflation will retake its place as the primary indicator for predicting Fed policy. Ahead of the Fed’s announcement, the Labor Department released its latest reading of the Consumer Price Index, which rose 0.5% in November from a year earlier. The CPI isn’t the Fed’s favourite inflation, and the collapse of energy prices are putting extreme downward pressure on overall prices. But you get the idea. The 2% target remains elusive. The Fed still has work to do.