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Fed Deviates from Historical Norm Despite Rate Increase

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Fed Deviates from Historical Norm Despite Rate Increase

December 15, 2016

The Federal Reserve has announced that it will raise its benchmark interest rate target for the first time this year and for only the second time since the Great Recession. The federal funds rate target, which was previously between 0.25 percent and 0.5 percent, is now between 0.5 percent and 0.75 percent. The effective federal funds rate has not been above 1 percent since 2008.

The Fed’s stated policy aims to balance two objectives: maximizing employment and keeping annual inflation close to 2 percent. But even as inflation has risen (the Fed’s preferred measure had annual inflation at 1.7 percent in October) and unemployment has fallen (it was 4.6 percent in the most recent jobs report), interest rates have remained near zero.

From a historical perspective, this is highly unusual. The last time the effective federal funds rate was below 1 percent, it was 1958—and even then, the rate stayed so low for only a year. How times have changed. Now, the federal funds rate has remained below 1 percent for nearly nine years.

To quantify just how unusual the new normal for monetary policy is, I examined the Fed’s behavior from 1959 through 2007. Specifically, I calculated how each month’s core PCE inflation rate and unemployment rate explained what the effective federal funds rate would be in the following month. Then, I applied the results to inflation and unemployment data since 2008 to “predict” what the federal funds rate would have been, roughly, had the Fed remained true to its pre-recession policies.

Under this model, the Fed still would have cut interest rates during the recession as unemployment rose. But the effective federal funds rate would have bottomed out at roughly 1.8 percent instead of plummeting to near zero. The Fed would have also begun its rate-hike process much sooner, raising rates throughout 2011 as unemployment fell and inflation gathered steam. Given current inflation and unemployment rates, I estimate that the effective federal funds rate would be roughly 4.1 percent today under pre-2008 policies. In reality, it is 0.4 percent.

This should not be considered a recommendation for Fed policy. Raising interest rates nearly four percentage points from where they stand today would be disruptive, to say the least. However, this exercise does illustrate just how far the Fed has deviated from the pre-recession status quo. Every month, the Fed’s post-recession eccentricity grows more and more unjustifiable.

Low interest rates are great for borrowers, from homeowners to the federal government. But a prolonged period of low interest rates squeezes the bank accounts of savers and retirees, and may also contribute to stock market bubbles. In addition, banks may be more reluctant to make riskier loans when low interest rates cut their profit margins, thus depriving the economy of the high-return investment it needs to jumpstart growth.

Though the Fed has argued for keeping rates low due to slow economic growth and a weak labor market, its own actions pre-2007 suggest the time for a rate hike is long past. The Fed made the right call in raising interest rates—let us hope it continues to move back towards the pre-recession norm in coming months.

Preston Cooper is a fellow at the Manhattan Institute. You can follow him on Twitter here.

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