Fed’s Announcement about the Federal Funds Rate

Mar 28th 2015

Thesis: Fed should be more patient to increase the federal funds rate because still inflation is not sufficient to boost the economy and the unemployment rate is higher than the boom cycle.

Fed have implicated that it would increase the short-term interest rate by midyear between June and September since January. Janet Yellen, Federal Reserve Chairwoman, gives a speech in front of economists in San Francisco, delivering that she is cautiously optimistic the economy is approaching the point where it doesn’t need the near-zero interest rates to make an expansion (Wall Street Journal). However, she emphasizes that the pace should be gradual, illustrating that it would move in small steps with enough caution to avoid undermining the economic expansion. Furthermore, Wall Street Journal explains what would make Fed halt the plan to begin raising interest rate. “In short, Ms. Yellen wants to be sure that inflation isn’t going to fall any further. It has been running below the Fed’s 2% goal for nearly three straight years. She says it is necessary to care about wage growth, core consumer prices, and other indicators of underlying inflation pressures before Fed increase the federal funds rate.

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I extract two graphs from St. Louis Fed’s FRED online tool, describing consumer price index in different time period. The first graph shows the general trend of consumer price index from 2008 to 2015 while the second graph illustrates some details between 2014 and 2015. Since consumer price index is related to the inflation (inflation is defined as a process of continuously rising prices), it is clear that Fed should worry about falling inflation problem since CPI is falling in 2015. Inflation can be an important measurement for boosting the economy, so Fed care about keeping the constant inflation. The problem is, if Fed increase the federal funds rate, the market will react as the inflation will fall down.

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I also generate the unemployment rate graph from St. Louis Fed’s FRED online tool to figure out the average unemployment rate of the U.S. According to Federal Reserve Bank of San Francisco website, the natural unemployment rate is around 5% while the current unemployment rate is about 5.5%.

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Increasing the interest rate can impact on the unemployment rate, which is not fully recovered. For example, the graph above shows the unemployment rate of 2006 and 2008, much lower than that of today. I think increasing the interest rate is risky in that sense. In addition, although the unemployment rate becomes lower and lower, there are numerous factors that we should consider before we assume that the number is correct. For example, many experts argue that the definition of the unemployment is not sufficient because it is subjective in terms of “willingness” and “active job search.” Also, Fortune points out the “aging population” affect on the unemployment rate because many baby-boomers are retiring now. Therefore, I believe Fed should be more patient to increase its funds rate because of low inflation and not sufficient unemployment rate.

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