by Shiv Palit
After months of public discussion and debate on whether or not the Federal Reserve should raise interest rates, the central bank has finally reached its conclusion. At the end of the two-day meeting that took place this Tuesday and Wednesday, Janet Yellen, the Chairwoman of the Federal Reserve, announced that the central bank has decided to wait for an interest rate increase. While the decision was not unanimous, 14 out of the 17 Fed officials agreed that a hike at the end of the year would be more beneficial and safer than now.
The last time the Fed raised the rates was in December 2015, the first increase in almost 10 years. “Our decision does not reflect a lack of confidence in the economy,” said Yellen. “It’s better to err on the side of caution." William Poole, the former president of the Federal Reserve of St. Louis, agrees with the Fed’s decision, citing that a premature interest rate hike would be detrimental to the economy. Furthermore, although continued low interest rates leave savers in a prolonged drought of low profits, traders benefit from the Fed’s decision as it leaves more room for market activity.
One of the primary motivations for the decision by the Fed is to continue the positive progress that has been occurring in the labor markets. With low interest rates, spending and business investment continues to be high. This keeps aggregate demand high, which subsequently helps employment levels. If interest rates were to rise, we would witness a stagnation in the labor market growth. Furthermore, current inflation rates are relatively low at 1.6%, so there is no urgent need to raise interest rates at the moment. When the labor market growth slows down, the Fed will need to raise interest rates in order to prevent high levels of inflation and economic stagnation. However, until that point, it would be safe to leave interest rates unchanged.
Apart from long-term benefits to the labor market, the announcement has also positively affected the stock market. Although financial stocks fell after the announcement, almost all of them (looking at you, Wells Fargo) had bounced back by the end of the day. Wall Street closed the day with the DJIA up by 0.9%, S&P 500 up by 1.09%, and NASDAQ up by 1.03%.
Although the interest rates will remain unchanged for now, Yellen agreed that it would be appropriate to raise them towards the end of 2016. While many economists are content with the Fed’s decision for now, there will soon be a need to increase interest rates. First, with the steady growth following the recession of the late-2000s, unemployment rates have been brought down to a safe 4.9%. Therefore, an increase in rates will not harm the economy and will result in higher returns for savers. Furthermore, the Fed aims to stabilize inflation rates at 2%, which they currently fall short of by 0.4%. Increasing interest rates will allow them to ensure inflation stability and appreciate the U.S. dollar in the international market, subsequently promoting import consumption. Additionally, with higher interest rates, banks will be more inclined to provide loans out of their reserves, and since credit remains tight at the moment, the lending will trigger additional credit flow, thus boosting economic growth. Last but not least, with increased interest rates, mortgage rates are likely to rise, which would benefit home owners who are hesitant to sell since it would increase housing prices and home equity.
As mentioned earlier, there is speculation that the Fed will need to raise interest rates towards the end of the year. The next policy meeting will occur in November, but many investors have ruled out the possibility of a policy change with the presidential elections being scheduled so close to the meeting. Some speculate that the December meeting will conclude in a rate increase of around 25 basis points. This would be enough time for the Fed to observe the effects on the stock market, labor market, and housing market. An extra three months also gives them more information to work with and therefore, allows more confidence in their decision.