The Federal Reserve has kept interest rates near zero since the financial crisis, the longest stretch of rates that low in more than half a century. By dropping the loaded phrase, the central bank will likely indicate that the moment to raise rates is coming soon, as early as June or, more likely, soon after.
Now the question is: How much and what impact will it have?
In December, the Federal Reserve’s open market committee revealed that nine of its 17 members expected to raise the federal funds rate to 1.125 percent by the end of 2015. Yet just three months later, the crumbling in the value of the euro, persistently low inflation, and modest economic growth in the United States have convinced most analysts that the Fed will not come close to hitting those numbers.
“I don’t expect that they’ll do more than a quarter point,” said Ed Yardeni, president and chief investment strategist of his own advisory firm Yardeni Research. “Bupkis as we say in New York,” he added, using a Yiddish word that has come to mean ‘absolutely nothing’ in English.
“I think they’ll do the bare minimum,” he added, “for credibility sake. To show they can. They haven’t had any practice.” He predicted that the Fed’s action will be described as “one and done.”
Indeed, the Federal Reserve has kept short-term interest rates in a target range of zero to a quarter of a percentage point for six years, an extraordinary and unprecedented effort to rebalance and restart the American economy after the financial crisis hit in late 2008. If the Fed raises those rates, it could increase the cost for Americans of mortgages, car loans and credit card debt.
Kenneth Rogoff, a Harvard economic professor and former chief economist at the International Monetary Fund, said that while uncertain about the timing, he expects the Fed’s first move to be a quarter of a percentage point.
“I can’t see why they would jump and move quickly,” he said. “It certainly will be a big percentage increase from nothing to something.” He warned that the central bank was still in “somewhat uncharted territory. They should be very cautious.” He added that the risk of choking the recovery prematurely was greater than the risk of seeing inflation “overshoot” the Fed’s 2 percent inflation target.
The last time the Federal Reserve altered its policy was when it said it would “taper” down its purchases of bonds and mortgage securities, ending an unusual program to bolster lending and jump start the economy still lagging from the 2008-09 financial crisis. Markets reacted badly. On Wednesday, the Fed’s open market committee is widely expected to drop the phrase that says it “can be patient” in weighing a rate hike, indicating that an increase could, but need not, come as early as June.
Now some analysts fear a “patience panic” similar to the “taper tantrum” the market threw earlier, driving down stock prices and raising medium- and long-term rates.
“A key factor here is how longer term rates respond. To some extent, increases in the target federal funds rate are already baked into long rates,” said N. Gregory Mankiw, a Harvard economics professor and chairman of the Council of Economic Advisers under President George W. Bush.
“If the Fed increases its target without surprising the bond market, there need not be substantial changes in long rates and so the adverse economic impact can be mild,” Mankiw said. “On the other hand, if the bond market gets surprised, then you could see long rates rise, as during the so-called ‘taper tantrum.’ Then the adverse economic impact would be more profound.”
Investors will be scouring Wednesday’s Federal Reserve statement and Fed chairman Janet Yellen’s remarks for clues about next steps.
“There are some reasons to be cautious in how early and fast one should raise short-term interest rates,” New York Federal Reserve president William Dudley said on Feb. 27 at a forum on U.S. monetary policy in New York City.
Dudley noted that “inflation is projected to stay for some time below the Fed’s objective of 2 percent” and said that “I believe that the risks of lifting the federal funds rate off of the zero lower bound a bit early are higher than the risks of lifting off a bit late. This argues for a more inertial approach to policy.”
Mankiw shares Dudley’s caution. “I think the Fed will and should start with modest increases and proceed with further increases only once there are clear signs that inflation is getting back up toward the target of 2 percent,” he said.
What areas would be hurt most by a rate increase?
New home buyers and those with adjustable rate mortgages could be vulnerable. Sam Kater, senior economist at CoreLogic, a real estate information and strategy firm, worries that abruptly higher interest rates could “do a fair amount of damage to an already nascent and weak housing recovery.”
Kater said that when interest rates rose rapidly in 1994 and 2004 many borrowers switched to adjustable rate mortgages, which offered lower short-term rates and the hope of lower rates in the future. But Kater said that a tighter regulatory environment for ARMs and more cautious lenders have reduced the availability of such mortgages.
“In short, in the past the mortgage market could buffer the impact by switching to adjustable rate products,” he said. Now, he said, “that is not the case.”
Banks could be more profitable — depending on how events unfold. Karen Shaw Petrou, managing partner of the advisory firm Federal Financial Analytics, says that banks and other financial institutions could be better off with higher rates — provided rates rise broadly because “rates are not only unusually low but unnatural and that has distorted financial markets.”
Petrou said that the spread between the cost of funds and returns on assets has averaged just over 3 percent, about a percentage point below historical norms. “If the rates are increased slowly and the market isn’t surprised and an increase comes in tandem with an economic recovery that the Fed justifies it on, then there’s nothing but good in this for the financial services industry,” she said. “It just all has to work as well as everyone hopes or there will be some bumps along the way.”
Household debt also remains a point of concern. It has declined from peak levels in 2008, and with low interest rates, it’s easy for households to cover payments on those debts and household debt service stands at historic lows.
“While many households still face challenges, the aggregate ratio of debt to disposable income in the household sector has decreased to a level last seen in 2002, as households have both increased their savings and reduced their borrowing,” said the new Economic Report of the President. “The combination of lower debt levels and lower interest rates has reduced the aggregate value of households’ debt service payments to 9.9 percent of disposable income, the lowest level since at least 1980.”
But the debt levels remain high by historic standards and whatever portion of interest costs are short-term will be affected.
Yardeni said that a modest rate increase won’t hurt those households, especially if long-term rates don’t rise much.
The international picture is also likely to color the Fed decision. Europe and Japan are struggling to get out of their own economic quagmires and the European Central Bank has launched its own “quantitative easing” program to keep interest rates low.
Rogoffwarns that raising rates too sharply could hurt emerging markets, which are simultaneously getting hit by low commodity prices. The drop in the value of the euro has already had the effect of a U.S. rate hike because it makes it harder for U.S. companies to compete and lowers the dollar value of international companies’ foreign earnings.
Yardeni said that about half of U.S. corporate profits come from overseas and if a strong dollar cuts that by 20 percent, that means a 10 percent drop in overall U.S. corporate profits. “Companies usually respond by cutting back on employment and capital spending.”
In addition, Rogoff said, a rate increase could “hit the federal government hard” by boosting federal borrowing rates.
The Congressional Budget Office said in a recent report that “when interest rates rise to more typical levels, as CBO expects will happen in the next few years, federal spending on interest payments will increase considerably.” The report forecast that the government’s net interest costs would “nearly quadruple from $227 billion in 2015 to $827 billion in 2025.”
It assumed that the interest rate paid on 3-month Treasury bills will rise from 0.1 percent in 2015 to 3.4 percent in 2018 and that the rate on 10-year Treasury notes will increase from 2.6 percent in 2015 to 4.6 percent in 2020 and beyond.
But investors in capital markets are putting their money in bonds on the assumption that rates will be much lower than that.
Above all, however, many economists say that the Fed should continue to let the economy get on firmer footing, even if inflation starts to rise closer to 2 percent.
“This time there a very strong case for waiting until the signs of inflation are undeniable,” said Rogoff. “And even if inflation expectations begin to get unmoored, which I think will take a lot longer than simply a few months of high inflation.”