Another Rate Hike

The FOMC just released its statement announcing that it has decided to increase the Federal Funds rate yet again by 0.25%, to 3.25%. This was expected. The only point of uncertainty was exactly what signal the Fed would send the market about future rate hikes. Would they suggest that this period of interest rate increases is coming to an end (as some commentators speculated this week), or do they still think that the economy is strong enough to withstand further rate increases?

Here is today’s FOMC statement compared to May’s statement. New additions to the statement are in boldface, while portions that were in the May statement but eliminated this time around are crossed out.

The Committee believes that, even after this action, the stance of monetary policy remains accommodative and, coupled with robust underlying growth in productivity, is providing ongoing support to economic activity. Recent data suggest that the solid pace of spending growth has slowed somewhat, partly in response to the earlier increases in energy prices. Although energy prices have risen further, the expansion remains firm and labor market conditions continue to improve gradually. Pressures on inflation have picked up in recent months and pricing power is more evident. Pressures on inflation have stayed elevated, but longer-term inflation expectations remain well contained.

The Committee perceives that, with appropriate monetary policy action, the upside and downside risks to the attainment of both sustainable growth and price stability should be kept roughly equal. With underlying inflation expected to be contained, the Committee believes that policy accommodation can be removed at a pace that is likely to be measured. Nonetheless, the Committee will respond to changes in economic prospects as needed to fulfill its obligation to maintain price stability.

My reading of this is that the FOMC thinks that the economy is doing fine, and doesn’t intend to stop its pattern of quarter-point rate hikes any time soon. (Of course, I’m assuming that the committee won’t have to revise this statement to correct a mistake, like they did last month…)

The chart below probably has something to do with this. With today’s rate increase, the real federal funds rate (which I’ve measured by subtracting the 12-month change in the GDP deflator from the interest rate) is just below 1%. But this is still far, far short of where the real federal funds rate typically is during periods of reasonably good economic growth.

If one believes in an exogenously ‘neutral’ real federal funds rate (as Greenspan seems to), the chart suggests that such a neutral fed funds rate is probably somewhere in the neighborhood of 3-4%. If inflation remains in the 2-2.5% range this year, it will take the FOMC more than 12 more months until the Fed’s “policy accomodation” has been fully removed at the current “measured pace” of quarter-point hikes. We still have a long way to go, in other words.

But I have my doubts about the concept of an exogenously ‘neutral’ interest rate. The reason is because I wonder if relative interest rates aren’t sometimes just as important as absolute levels of interest rates when it comes to influencing business and consumer spending decisions. So while today’s interest rates are indeed low in an absolute sense, I worry that raising interest rates will still chill economic growth from its current level, which is only mediocre to begin with.

However, I am also sympathetic to the idea that the Fed needs to store up ammunition for the next economic slowdown, and thus needs to raise interest rates today while it can. This leaves me feeling fairly ambivalent about whether the Fed should keep raising interest rates.

At any rate, I’m not the one making the decision. That’s up to Alan Greenspan. And from today’s statement, it looks like we’re in for further increases in short-term interest rates, for at least a little while. After that, it’s anyone’s guess.

Kash