Fed's Rate Hike Done Deal; Policy Path Mechanics the Next Challenge

A total of 211,000 fresh jobs were added to the US economy during November 2015- more than double the 100,000 fresh jobs required to absorb the economy’s incoming labor force every month. A series of such reassuring economic trends are hinting at macroeconomic firmness in the economy, thus providing impetus to what now seems to be a “done deal”- a hike in short-term interest rate by the Janet Yellen-led Federal Reserve during its December 15-16 meeting.

The Case for Interest Rate Hike: Employment and Price Stability

Maximum Employment and Stable Prices are two of the Federal Reserve’s three objectives as enshrined in the Federal Reserve Act 1913 (the third being long-term interest rates). Figures 1 and 2 show how these two critical indicators of economic performance have varied over time.

Figure 1

Figure 2
In March 2015, the Federal Reserve suggested that the economy’s long-run unemployment rate (or the natural rate of unemployment) falls within the 5.0-5.2% range. While the suggested natural rate of unemployment may itself be subject to debate, it is beyond doubt that unemployment has moderated to pre-recession levels. Figure-1 suggests that unemployment in October 2015 dipped to 5%- a level last witnessed in April 2008. The number has remained unchanged for November 2015 as per latest official data (not shown in Figure-1). This implies that for the last 4 months, the rate of unemployment has remained within the suggested band of natural unemployment- a phenomenon last witnessed during the four month-period ending April 2008.The fact that this moderation has been witnessed for employees across educational categories further hints at inclusive recovery in the labor market.

On the unemployment front, thus, the economy is sending out the right signals. Unlike Figure-1, however, the metrics shown in Figure-2 are not as symmetric. Overall inflation, as measured by the Consumer Price Index, seems to have hovered around the 0% mark during 2015. This is way below the 2% long-run inflation rate that the Federal Reserve is seemed to be comfortable with. A closer look at the other inflation metric -Core Inflation Rate (defined as overall inflation minus prices of volatile items such as food and energy prices)- however, hints at a different story. Despite the CPI inflation rate flirting with the 0% mark, core inflation has been persistent in the 1.6-1.9% range.

The divergence is largely on account of falling food and energy prices across international markets. For instance, CPI inflation rate trends suggest that the most dramatic drop in the recent past was witnessed after December 2014. This almost exactly coincides with the slump in international crude oil prices; a phenomenon that continues to play out due to international economic and geo-political factors. In any event, it is, in fact, due to the inherent price volatile nature of food and energy that policy makers prefer core inflation to overall inflation. It will, thus, be fair to conclude that while not intuitive at first glance, the inflation story too suggests that a return to conventional monetary policy is, in fact, not opposed by economic fundamentals.

A Small Hike; A Wait-and-Watch Approach

Two of the Federal Reserve’s policy’s primary guiding parameters- inflation and unemployment-thus, support a tightened monetary policy. It is, however, expected that the FOMC will announce a hike of no more than 0.25%. The small magnitude of the expected hike is in line with underlying domestic and international economic realities. More importantly, a return to normalcy after years of ultra-low interest rates will be characterized by a wait-and-watch approach. There are a handful of important reasons that merit such an approach.

Higher interest rates are expected to affect the domestic economy through various channels. These adversely affect private consumption and investment through higher borrowing costs. By hiking the US government’s borrowing costs, a tighter monetary policy will further reduce Washington’s ability to borrow and spend. Nevertheless, unless the hike is dramatic, these effects will be inconsequential. A modest hike will, thus, allow the Federal Reserve to observe the economy’s reaction to the changed scenario, while not hurting it.

Furthermore, in a period of ultra-loose monetary policy across advanced economies- the USA, the Eurozone, the UK and Japan- the Federal Reserve is gearing up to initiate a phase of monetary policy divergence, which has not been observed since the crisis. On the face of it, the USA plans to move to a regime of normal monetary policy, while other advanced economies (except the UK, perhaps) will continue to maintain easy monetary policies. The divergence will pave way for a nominally stronger US Dollar. In addition, because the USA maintains a healthier inflation rate when compared to the more benign inflation rates across other advanced economies, monetary policy tightening will further cause real appreciation of the US Dollar, thus, harming US exports.

Finally, a gradual move towards normalcy will also allow emerging market economies (EMEs) to adjust their policies accordingly. Memories of the aftermath of the 2013 EME sell-off in the wake of Ben Bernanke’s “taper tantrum” are fresh in the mind. Complicating issues further is the slump in commodity prices, which has placed emerging economies like Brazil and Russia in an even more precarious position when compared to 2013. Apart from creating an unstable international economic environment, an EME sell-off induced by the Federal Reserve’s policy action will trigger a capital flight back to the USA, thus causing nominal appreciation of the US Dollar in the short-run.

It, thus, seems that the Federal Reserve's December 15-16 meeting will result in the first hike in short-term US interest rates in nearly a decade. While economic evidence might not oppose monetary tightening, the Federal Reserve’s policy path towards normalcy will not be straightforward. Therein lies Yellen’s next challenge.  
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