Why is the Fed Still Raising Interest Rates?

The Federal Reserve has been on an interest rate hiking spree in the past couple of years. IN 2018, the Fed raised interest rates four-time, each time the rates were raised by 250 basis points. In 2019 too, these rate hikes are bound to continue. The Fed has acknowledged that it will hike rates by as many as three times in 2019. This consistent upward pressure on the interest rates has irked President Trump as well. According to him, consistent increases in the interest rates are having a negative impact on the economy. This is why he claimed that the Fed is going loco (crazy) and hence must be stopped.

Up until now, Fed chairman Jerome Powell has not paid any heed to the advice of President Trump. As a result, the interest rates have continued to grow unabated. However, persistent hikes bring in the question as to why is it important to raise the interest rates right away and how does the Fed decide when the rates will be hiked.

In this article, we will have a closer look at some of the possible reasons behind the consistent rate hikes being ordered by the Fed.

Low Real Interest Rates

Firstly, it needs to be acknowledged that the current interest rates in the United States are perhaps the lowest in its history. The rates were brought to near zero levels after the Great Recession started in 2008. Ever since they had not been raised for a very long time. The real interest rates in the United States are close to zero as of now. The nominal interest rates are 2.5% whereas the inflation percentage is close to 2%. Hence, the effective interest rates are close to 0.5%.

It needs to be understood that low-interest rates create problems for everybody. Businesses are tempted to undertake projects which do not provide the best yield. Banks end up lending money to these businesses. Finally, governments also tend to raise a lot of debt during periods of low-interest rates.

This could be one of the reasons why the Fed is hell-bent on raising interest rates. Maybe it wants to prevent wrong investments and for this reason, is ignoring the advice being given by President Trump.

Experimenting to Find Neutral Interest Rates

It is also possible that the Fed could be experimenting with the economy to find the neutral rate of interest. This is a plausible explanation given the fact that the Fed has raised interest rates about 5 times by small amounts. It appears as if the Fed is testing the waters.

As per economic theory, neutral interest rates are an equilibrium point. If the interest rates are at this point, they provide optimum benefits to the economy. They do not cause inflation and do not impede growth either. However, this neutral rate cannot be worked out using a mathematical formula. Rather, finding the optimal neutral rate is a process which involves trial and error. That is exactly what the Fed seems to be doing as of now. It is possible that the Fed will keep on raising interest rates till it starts negatively affecting the economy. Once there is a negative effect, the Fed may simply stop raising rates any further.

Preparing for the Downturn

It is also likely that the Fed is making arrangements to be able to come to the economy’s rescue when it runs into trouble. It needs to be understood that this is the longest running bull market in the history of the stock market. As a result, it wouldn’t be paranoid to assume that the stock market may be in for a downturn in the near future.

The situation may not be as bad as the 2008 crisis, but the downturn surely is imminent. The last three times the economy ran into trouble, the Fed came to their rescue. The Fed helped the economy by cutting the interest rates. Each time, the Fed had reduced the rates by close to 5%.

However, at present, the interest rates are at 2.5%! Hence, if a recession strikes, the Fed can only reduce interest rates by 2.5% before it hits zero. Therefore, it is possible that the Fed is slowly driving the interest rates to 5% without disturbing the economy. Once it reaches that level, it can afford to drop the rates back when a recession strikes.

The central bank of Europe has reduced the interest rates to below zero in the recent downturn. However, the effects of that on the economy are yet to be gauged. This is the reason why the Fed can’t count on it and is being forced to increase interest rates.

Confidence in the Economy

Lastly, it may also be possible that the Fed has a lot of faith in the American economy. The unemployment rate is lower than the government’s target. Also, the inflation rate is lower than the target. Hence, the Fed does have some wiggle room to adopt more stringent monetary policies.

The bottom line is that the Fed is doing the right thing by raising interest rates in good times. Politicians tend to chase growth in the short run. However, this negatively impacts the economy in the long run. Donald Trump just wants to show that his numbers are better than that of his predecessors. He doesn’t seem to have any knowledge about or any interest in the real economy. Hence, his advice should be ignored.

❮❮   Previous Next   ❯❯

Authorship/Referencing - About the Author(s)

The article is Written and Reviewed by Management Study Guide Content Team. MSG Content Team comprises experienced Faculty Member, Professionals and Subject Matter Experts. We are a ISO 2001:2015 Certified Education Provider. To Know more, click on About Us. The use of this material is free for learning and education purpose. Please reference authorship of content used, including link(s) to ManagementStudyGuide.com and the content page url.

Corporate Finance