Feb 9th 2015
Nowadays, the Fed faces with the severe dilemma between low inflation and job gains. The unemployment rate has fallen to 5.7% from 6.6% a year ago and 8% two years ago while the inflation rate is still below the target 2% rate. According to Wall Street Journal, the stronger job market provides reason of raising short-term interest rates to prevent the overheating market while low wage growth and inflation show the signal that overheating problem wouldn’t be in the near future.
Officially, the Fed already said a high possibility of raising short-term interest rate around the midyear. However, many Fed officials worry about the market situation although net hiring increases during the November-to-January by more than 1 million. Their worries come from the inflation which is still below the Fed’s 2% objective and little wage growth. Why does low inflation matter? It is a simple economic theory called Phillips curve. Basically, it is a historic inverse relationship between unemployment rates and inflation rates in the economy. In theory, there is a point where the long-run Phillips curve meets the short-run Phillips curve, where the Fed and other governments target on.
“Economists call this cutoff point a non-accelerating inflation rate of unemployment, or Nairu, and also point to a “natural rate” of unemployment where inflation is stable in the longer-run. The problem is nobody knows the cutoff point. Economists merely estimate it” (Wall Street Journal). Because of uncertainty in estimating the point, it is hard to set the interest rate at the right time. Both Fed officials and policy makers want to see the obvious sign to make sure that the economy is close to the full employment, but not as much as to the overheating point.
There are two options for Fed; it can be patient until the market shows a clearer sign or take an action by increasing short-term interest rate. Personally, I am in the position that Fed should wait because I think raising the interest rate is too risky. As Rosengren said, “Low level of inflation in most developed economies meant the U.S. central bank shouldn’t hurry to raise interest rates.” Furthermore, still the economic measures are not fully recovered as before the sub-prime mortgage. For example, many people point out involuntarily part-time workers, which make “job gains” doubtful. “There are still almost 7 million workers counted as employed who say they are working part-time involuntarily” (Wall Street Journal). Fed should be more careful about its increasing interest rate unless the whole economy falls into the deep recession again.
The auto industry is always a good indicator of how the economy is performing. Household consumption is up and with that, so are auto sales. In January, GM, Ford, Chrysler and Toyota all saw double digit percentage increases. In a time where credit is not too difficult to obtain and interest rates remain low, consumers are taking advantage by buying new vehicles. According to expert reports, US auto sales are expected to be up 15% from a year ago. GM sales chief Kurt McNeil said, “Consumers feel good because more people are working, the U.S. economy is expanding and fuel prices are low.” http://www.wsj.com/articles/chrysler-sales-jump-in-january-1422968401?mod=WSJ_hp_LEFTWhatsNewsCollection. Low fuel prices are key as this represents a major expense post purchasing a car. While numbers can be skewed by weather patterns and other one time occurrences, it appears as if the fundamentals of the industry remain strong. After 2008, many car companies dove into a dark place. Major internal changes and restructurings appear to have worked and are starting to pay dividends. According to WardsAuto.com, factory utilization is at an all time high. Many companies were forced to close production plants in 2008 due to massive losses. This has ended up working out well and has led to more efficient uses of production space. I am concerned with this recent trend of new car sales for a couple reasons. Where have we heard easy credit before? This trend of lending to potentially subprime borrowers is exactly what got banks into trouble in 2008. If lending remains easy and interest rates remain low, who knows if we will see a 2008 repeat itself. The economy is cyclical by nature but fluctuations do not need to be as extreme as they were in 2008. Many experts in the industry do not believe that we have anything to fear. According to a recent article that examined the recent industry sales spike, “The latest sales spurt, coming after the “stellar” figures for December 2014, has scotched fears that growth in the US auto market might be abating after years of strong recovery from the market’s near-collapse in early 2009.” http://www.ft.com/cms/s/0/aa4c8326-abb4-11e4-b05a-00144feab7de.html#axzz3QilwUwoy. The fact that all fears are gone is a little concerning. Once oil prices being to increase and the Fed beings to raise rates, what will these car companies do to remain profitable. Consumer spending remains strong which is a good indication that sales could remain strong. However, these companies need to figure out ways to remain profitable and never relax just because they has a few good months. Leaders of these companies need to remember where they were a few years ago.
Before I talk about the Fed’s decision on Wednesday, I think it is crucial to talk about what the Federal Reserve is so we can have a better picture of what is going on. As most people know, the Federal Reserve is the central bank of the United States. However, some people do not know its important roles of the Federal Reserve. In the United State’s history, a Federal Reserve Bank did not exist for very long time until they encountered with the event when the New York Stock Exchange fell over 40 %. People finally wanted to introduce the idea of a central bank that can control the money supply, interest rates, and overall banking system.
Then what does the Federal Reserve do now? Simply, the Fed has the ability to control or execute “monetary policy”, which is an economic policy that promotes the economic health of the United States. Monetary policy is one of the ways that the Federal Reserve uses, which controls the growth of money supply. Therefore, the Fed regulates the discount rate, reserve requirements and open market operations through monetary policy. According to the Federal Reserve, “The discount rate is the interest rate charged to commercial banks and other depository institutions on loans they receive from their regional Federal Reserve Bank’s lending facility- the discount window”. Reserve requirements are the amount that a bank has to hold in reserves.
As shown above, the Federal Reserve serves a substantial role in the economy of the United States that can stimulate the economic health of the United States. This is why it is important to understand what decision the Federal Reserve made on January 28.
For 2015, the Fed said that they would not heavily rely on hyper-expansionary monetary policies. Moreover, the Federal Reserve made a decision to keep short-term interest rates low until at least the summer. Economic activity shows a good pace and unemployment rate has been decreasing compared to last year. However, the central bank is also expecting low inflation, slow global growth, a stronger U.S. dollar and international market turbulence. Although other central banks of other countries lowered their own interest rate and weaken their currencies to fight against inflation and soft growth, Michael Gapen, Chief U.S. economist at Barclays Capital and a former researcher in the central bank’s monetary affairs division said, “The Fed is in a wait-and-see mode”. But the real question we have to ask ourselves is “can capitalism works without a presumed minimum level of inflation”?