On January 28th, the Federal Open Markets Committee (FOMC) made its latest statement on its stance on monetary policy going forward. The Fed is committed to keeping the federal funds rate between 0 and 0.25% until their employment and inflation objectives are met. Compared to its last statement, there are a few subtle changes that will play a large role in the Fed’s decision to raise short-term interest rates in the near future.
Inflation has declined further below the Committee’s longer-run objective, largely reflecting declines in energy prices.
The Fed’s target for unemployment is fairing much better than its target for inflation. The target range for unemployment the Fed sees consistent with 2% inflation in the long run is between 5.2% and 5.5%; the current jobless rate is very close at 5.6%. However, inflation is slowing. As you can see, even after excluding food and energy prices, prices still seem to be slowing. If unemployment continues to truck lower, it would support a rate hike, but low or falling inflation would say otherwise. Until inflation seems to be stable, I don’t see the Fed raising short-term rates, given some of the other threats affecting the US economy.
This assessment will take into account a wide range of information, including measures of labor market conditions, indicators of inflation pressures and inflation expectations, and readings on financial and international developments.
In determining whether to maintain its current course, the Fed has to consider international issues as well as domestic ones that could very well affect US growth. I believe the Fed is specifically talking about Europe in its statement. Because of slowing global growth, recent developments in Europe and the announcement of their new stimulus program, and a stronger US economy, capital has been flowing into the US and the dollar has appreciated against most foreign currencies. A stronger US dollar makes US goods more expensive to foreigners, which will probably decrease domestic exports in the near future. A stronger US dollar also makes foreign goods cheaper, which has the potential to put even more downward pressure on inflation. The possibility of slower growth and disinflation will puts the Fed in a situation where they need to keep rates lower.
The Committee currently anticipates that, even after employment and inflation are near mandate-consistent levels, economic conditions may, for some time, warrant keeping the target federal funds rate below levels the Committee views as normal in the longer run.
The Fed’s statements are carefully curated so they have the flexibility to do what they believe is right for the economy at the right time. I believe the biggest mistake the Fed can make is raising interest rates too early. If they raise rates too early, economic growth will be hit at a time when we actually need lower rates and more stimulus. If the Fed waits longer, inflation could be a little higher than the long run 2% target, but the ensuing rate increase would help control inflation. The upside from putting off rate hikes greatly outweigh the downsides from raising rates too early, therefore, I suggest the Fed stay patient and continue its course until the latter part of 2015.