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Economics

Why Is the Fed Still Raising Interest Rates?

Dec 27, 2018 Martin Feldstein

Given that the US Federal Reserve has long said that its interest-rate policy is “data dependent,” why has it pressed ahead with monetary tightening in the face of worsening economic indicators? Three reasons stand out.

CAMBRIDGE – Earlier this month, the US Federal Reserve’s policy-setting Federal Open Market Committee (FOMC) voted unanimously to increase the short-term interest rate by a quarter of a percentage point, taking it from 2.25% to 2.5%. This was the fourth increase in 12 months, a sequence that had been projected a year ago, and the FOMC members also indicated that there would be two more quarter-point increases in 2019. The announcement soon met with widespread disapproval.

Critics noted that economic growth has slowed in the current quarter and that the Fed’s preferred measure of inflation (the rate of increase of the price of consumer expenditures) had fallen below the official 2% target. Given that the Fed has long said that its interest-rate policy is “data dependent,” why did it press ahead with its previously announced plan to continue tightening monetary conditions?

The FOMC statement announcing the latest interest-rate hike gave no explicit reason for it. Fed Chair Jay Powell’s remarks at his press conference also gave no reason for maintaining the originally planned rate increase despite the economic slowdown.

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Martin Feldstein

Writing for PS since 2008
130 Commentaries

Martin Feldstein was Professor of Economics at Harvard University and President Emeritus of the National Bureau of Economic Research. He chaired President Ronald Reagan’s Council of Economic Advisers from 1982 to 1984. In 2006, he was appointed to President Bush's Foreign Intelligence Advisory Board, and, in 2009, was appointed to President Obama's Economic Recovery Advisory Board. He was also on the board of directors of the Council on Foreign Relations, the Trilateral Commission, and the Group of 30, a non-profit, international body that seeks greater understanding of global economic issues.

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0 Comments on this paragraph, 5 Comments on this article

Janos Nagy Dec 30, 2018

That hilarious interest rates are data dependent not market dependent.
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Sergio BULIAN Dec 30, 2018

I share analysis and above all the conclusions.
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georges makhtouf Dec 29, 2018

there are enough warning signs – including falling equity prices,"

This is a circular argument as the falling equity prices were directly caused by poor communication of Fed policy, beginning in October. From April to September equity prices rose steadily.

It's worth noting that Fed policy was widely anticipated: a 4th rate hike in December had been priced in since late spring and the $50 billion/month reduction in the balance sheet was also widely known.

So it was not the *content* of Fed policy that was the cause of equity price declines but rather its poor communication by one individual at the Fed, Chair Jerome Powell. Witness his early October statement that interest rates "are a long way from neutral", followed by the stock market crash beginning Oct 10. Mr. Powell reversed himself the following month, claiming interest rates "are just below the neutral range of estimates", helping the market recover in November. A good way for the Fed Chair to lose credibility and confidence is to take two diametrically-opposed stances on interest rates in the space of a few weeks.

The second big failure was Mr. Powell's Dec 19 press conference, especially his comment that balance sheet reduction was "on auto-pilot", which was interpreted as $50 billion/month is a near-religious goal at the Fed and impervious to economic data. This damage was reduced two days later when John Williams, President of the NY Fed, used Mr. Powell's words to contradict him in a live interview, explicitly saying that nothing at the Fed was on auto-pilot but that, based on current data, $50 billion / month of balance sheet reduction continues to be warranted.

Interest rate increases are important in reducing the attractiveness of high-risk investments, rather than for allowing future interest rate reductions to combat a recession (that might well have been triggered by current interest rate rises). The lowered equity prices of the 4th quarter were caused mostly by poorly judged statements from Mr. Powell than by the content of Fed policy.

Creating a new role of Fed Spokesperson, and assigning Mr. Williams to it, would allow the Fed to communicate its current policy in a way that reassures financial markets rather than panicking them.
A new reply to this comment has been posted.
georges makhtouf Dec 29, 2018

" there are enough warning signs – including falling equity prices,"

This is a circular argument as the falling equity prices were directly caused by poor communication of Fed policy, beginning in October. From April to September equity prices rose steadily.

It's worth noting that Fed policy was widely anticipated: a 4th rate hike in December had been priced in since late spring and the $50 billion/month reduction in the balance sheet was also widely known.

So it was not the *content* of Fed policy that was the cause of equity price declines but rather its poor communication by one individual at the Fed, Chair Jerome Powell. Witness his early October statement that interest rates "are a long way from neutral", followed by the stock market crash beginning Oct 10. Mr. Powell reversed himself the following month, claiming interest rates "are just below the neutral range of estimates", helping the market recover in November. A good way for the Fed Chair to lose credibility and confidence is to take two diametrically-opposed stances on interest rates in the space of a few weeks.

The second big failure was Mr. Powell's Dec 19 press conference, especially his comment that balance sheet reduction was "on auto-pilot", which was interpreted as $50 billion/month is a near-religious goal at the Fed and impervious to economic data. This damage was reduced two days later when John Williams, President of the NY Fed, used Mr. Powell's words to contradict him in a live interview, explicitly saying that nothing at the Fed was on auto-pilot but that, based on current data, $50 billion / month of balance sheet reduction continues to be warranted.

Interest rate increases are important in reducing the attractiveness of high-risk investments, rather than for allowing future interest rate reductions to combat a recession (that might well have been triggered by current interest rate rises). The lowered equity prices of the 4th quarter were caused mostly by poorly judged statements from Mr. Powell than by the content of Fed policy.

Creating a new role of Fed Spokesperson, and assigning Mr. Williams to it, would allow the Fed to communicate its current policy in a way that reassures financial markets rather than panicking them.
A new reply to this comment has been posted.
michalis trepas Dec 28, 2018

"these central banks raise normalize their rates"
I think we have a minor typo here, or a "-" is missing between "raise" and "normalize". A good article, this one.
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