The financial media’s breathless commentary about rate hikes by the U.S. central bank is silly. And that’s why (except for what I’m writing here!) you should ignore it. But I also like pointing out obvious things that actually, well, aren’t that obvious.
On Wednesday afternoon, the Federal Reserve (the Fed) will announce whether it’s going to raise the federal funds rate by 0.25 percent. This is the interest rate the U.S. central bank charges to lend money to other U.S. banks, which is currently set at a range of 0.25-0.50 percent.
Even though one interest rate hike doesn’t make a huge difference, it’s all about the trend. And when the Fed does raise interest rates, other central banks around the world will likely start doing the same thing. This would lead to higher lending rates for borrowers… and possibly higher returns on cash for depositors. And as we saw after the Fed raised interest rates in December, stock markets are primed to fall at any hint of a rate hike.
The odds of a rate hike
Most investors don’t think the Fed is going to raise rates this time around. (Janet Yellen, the head of the Fed, said this a few weeks ago: “In light of the continued solid performance of the labor market and our outlook for economic activity and inflation, I believe the case for an increase in the federal funds rate has strengthened in recent months.”) Of course, the Fed changes its mind, frequently. And that’s all right – the Fed is only human, of course.
Right now, markets think there’s a 20 percent chance that the Fed will raise rates, as shown in the graph below. As recently as August, the odds were closer to 40 percent. And though it’s a bad idea to say “never,” the Fed generally tries to avoid surprising markets.
What the numbers say
More to the point, the data suggests that the Fed would be ignoring an important comparison if it raised interest rates. Higher interest rates reflect in part a strong economic environment – that is, an economy that will be able to continue to grow even if capital is (slightly) more expensive (and companies and normal people would thus tend to borrow less – which could hurt economic growth).
The table below shows the data that was available to Fed policy makers just before they announced the third round of quantitative easing (QE3) in September 2012. That was a continuation of the post-global financial crisis effort to boost economic growth. These are some of the data points that the Fed relies on to guide its decisions about when, and whether, to raise interest rates.
What this shows is that the state of the American economy when QE3 was announced was, on some fronts, much more healthy than it is today.
American economy in September 2012, retail sales growth and GDP growth were stronger than they are today. Durable goods orders, which shows the orders placed with U.S. factories for hard goods, were very similar to what they are now. And inflation was higher 4 years ago than it is now – still within acceptable limits, but almost double today’s inflation rate.
Today’s American economy is in a better state than it was in 2012 on other parameters, like the unemployment rate, construction spending and housing starts. But by no means is the American economy now in such better shape than it was four years ago.
Put it this way. Four years ago, you had a fever of 39 C (102 F), a twisted ankle, and a runny nose – so you stayed home. Today, you have the flu, a broken foot, and pinkeye. So would you now consider entering the local 5 km Sunday Run for Charity? Probably not. And if you did, you probably wouldn’t make if off the starting line.
That’s why the Fed probably won’t raise interest rates tomorrow – the American economy may not be in good enough shape to absorb higher rates and continue growing. And before putting too much faith in the pronouncements of Janet Yellen and her friends, look at the context of the U.S. economy.