Number of pieces increasing in Fed rate hike puzzle

Number of pieces increasing in Fed rate hike puzzle

Inflation and unemployment are no longer the only big issues for the US Fed to consider in deciding when to raise interest rates. Oil prices and the strong dollar, among other factors, make the Fed’s timing much more difficult.

The US Federal Reserve’s March statement made clear that there was no single narrative for the health of the US economy and the timing of the Fed’s first increase in interest rates.

That is in stark contrast to just six months ago, when it appeared that US economic growth was accelerating and would necessitate a rate hike in the first half of 2015. Since then, increasingly complex obstacles to the Fed’s path have emerged, such as oil prices and the strong dollar. Beyond that, the Fed will have to make determinations on all the following issues as it raises rates.


The Fed’s dual mandate tasks it with maintaining maximum employment, a goal that has nearly been achieved. The unemployment rate in February was 5.5%, the lowest since May 2008—fast approaching the long-term non-accelerating inflation rate of unemployment (NAIRU).

However, the employment situation is not that straightforward: slack in the labor market, which Chairwoman Yellen brought to the fore last year, is still much higher than pre-recession levels.

The slack lends credence to the case for raising rates later in the year or even in 2016. According to Johns Hopkins University Professor of Economics Laurence Ball, the best way to reduce labor market slack is to keep rates near zero until unemployment is well below 5%, even if it spurs inflation.

Such a bold move likely does not have enough support on the Federal Open Market Committee (FOMC), and certainly not among congressional leaders already antagonistic towards the Fed.


The other side of the dual mandate, maintaining 2% inflation, is equally challenging and convoluted. There were already questions about whether the US economy would hit the inflation target before oil prices started falling, but now there is no question.

The Fed’s preferred inflation measure, PCE inflation, was 0.2% in January—1.5% excluding food and energy. While the Fed prefers to make policy decisions based on core PCE inflation, because temporary external pressures should rarely be taken into account for good monetary policy, the downward pressure on inflation from oil prices is impossible to ignore.

While inflation looks extremely low now because of oil, it is only a comparison to last year. Once the US begins annualizing low oil prices in the second half of the year, inflation will begin creeping up. After all, cheap oil’s expansionary effect on consumer spending will accelerate inflation in other sectors of the economy. If oil prices begin rising materially, inflation could hit the target even more quickly.

Economic growth

After the US economy grew 5% in the third quarter of 2014, there was widespread optimism that the US had finally embarked on a long-awaited robust recovery. Yet, as fast as the growth came, it seemingly disappeared.

During the last three months of the year, the economy only grew at 2.2%. In the Fed’s last statement, the FOMC noted that growth had ‘moderated’—a downgrade from its previous assessment that growth was ‘solid’—and shaved 0.3% off its 2015 GDP growth projections. With Chairwoman Yellen’s generally dovish stance, it is unlikely that any rate increase will occur if doubts about the health of the economy remain.

Oil prices

The risk that low oil prices pose for the Fed has evolved considerably since last fall. What used to seem like a short-term boon for the consumer now is much more complex. Because energy prices are volatile and hard to predict, the Fed should not take them into account for policymaking decisions.

While former Fed chairman Ben Bernanke advocated that the Fed not make policy based on volatile and unpredictable energy prices, the Fed cannot ignore the fact that low oil prices are having a major impact on inflation anymore—even if it is not affecting core inflation.

It will also likely be careful in light of the varying impacts of low oil prices: consumer spending is increasing, but financial hardship in the oil and gas industry will result in layoffs and potential stress in the high-yield bond markets from the threat of defaults. Oil fracking companies have been aggressively converting assets to cash to pay off debt that low oil keeps them from paying, but once those assets are gone the threat of default across the industry could rise substantially.

Strengthening US dollar

Along with oil prices, the six-month rally of the US dollar against world currencies poses the newest and biggest complications for the Fed. The 20% increase in the Dollar Index since last March is a sign that the US economy is strengthening—and at first seemed positive for the US economy. US consumers purchase a large amount of imported goods, which are now relatively cheaper. If the Fed took action based on the strong dollar last fall, it would have been to raise rates sooner.

As the dollar’s rally accelerated, to the point where it is nearly at parity with the euro for the first time since 2003, it became clear that there is no such thing as a free lunch.

International revenue from US companies is shrinking because of the negative currency translation. A majority of companies providing guidance have warned that earnings will fall short of expectations in the first quarter of the year and currency has been a major reason.

The longer the dollar stays high, the more the drag on US companies will spill over into the broader economy, with corporate cost cutting resulting in less growth and employment.

While the Fed has no interest in a global currency war, the real effects of currency translation are starting to have a negative impact on the US economy and build a case for keeping rates near zero for longer than previously thought.

Wage growth

For inflation to pick up towards the Fed’s target, wages will have to begin growing faster than they have since the recovery began. After promising numbers in January, February wage growth was 2.0% for private workers. The issue holding paycheck growth down has been, and still is, slack in the labor market. It is likely that the large pool of available workers wipe out employees’ ability to negotiate higher wages.

In the past, Chairwoman Yellen has indicated that wage growth and labor market slack are higher priorities for her policymaking decisions than for previous Fed leaders. While the recovery could be robust enough to necessitate a rate increase without a significant uptick in wages, faster wage growth seems to remain a key for convincing Chairwoman Yellen to give the go-ahead on higher interest rates.

Gradually letting down equity markets

Part of the goal of quantitative easing was to push investors into more risky assets to stoke growth in the risk-averse aftermath of the financial crisis. The effectiveness of QE has been up for debate since, but one nearly unanimously agreed-upon aspect has been that US equities have benefitted. Not only did more investors put money in equities, but low rates improved public companies’ balance sheets.

So how does the Fed carefully take away the punchbowl without killing the party?

That’s a question that the Fed has struggled with for decades, but this time the punchbowl is bigger and more potent than ever. Markets will be spooked by the first increase, at least for a short time, but the Fed’s messaging will be key in determining how long that lasts.

International easing

As discussed in the most recent GRI newsletter, two dozen central banks have lowered interest rates this year. The US is in an enviable position because its economy is strong enough to consider raising rates, but the stark divergence of policy from other parts of the world presents its own problems.

Raising rates now will exacerbate the issues presented by a strong dollar. It will have an outsized effect on financial markets, even if the effect on the broader economy is small, as assets flow away from US equities and emerging markets and towards US bonds and European equities.

The first rate hike is the easiest part

The exact date of the first rate increase, in the larger scheme of things, will not have big implications for most of the economy; it will mainly affect traders.

By contrast, the pace and timing of subsequent changes will determine whether the economy is stifled or overheated by the Fed. The first increase will matter for a few months, while the rest will have consequences for a number of years.

Given the measured attitude towards raising rates that Chairwoman Yellen has communicated to markets, it is likely that subsequent rate hikes will not be fast or arbitrary.

Expected Future Fed Funds Rate

Source: CME Group

For now, markets are expecting that rates will increase at the September FOMC meeting and will rise at a steady pace at each following meeting.

Categories: Economics, North America

About Author

Alex Christensen

Alex is an Editor at Global Risk Insights, who also currently works in investment research. His work on political risk and economic policy has appeared in many forums, including Business Insider, Seeking Alpha, & The Emerging Market Investors Association. He holds a Master’s in Economics from the London School of Economics and BA from Washington University in St. Louis.