Economic Recovery: The New Normal in Interest Rates

BY ITAMAR WAKSMAN

(By Dan Smith - Own work, CC BY-SA 2.5, https://commons.wikimedia.org/w/index.php?curid=27323)

The Federal Reserve headquarters in Washington, DC. (By Dan Smith – Own work, CC BY-SA 2.5, https://commons.wikimedia.org/w/index.php?curid=27323)

In a meeting on April 27, the Board of Governors of the Federal Reserve once again decided to halt their plans of raising rates, and to keep the federal funds rate, or the interest rate banks charge each other to borrow money, between 0.25% and 0.5%. Beginning in 2008 with the start of the Great Recession, the Fed was compelled to use Open Market Operations to lower the funds rate to 0%, predicting that these historically low interest rates would encourage widespread borrowing and stimulate economic growth. The Fed originally did this to temporarily provide aid for a much larger problem, insisting that fiscal stimulus from policy makers in Washington would be necessary to restore the U.S. economy. However, when partisan politics choked the stimulus package in Congress, it became clear the nation’s needs were not going to be met. The Fed consequently embarked on an extreme program of Quantitative Easing, while simultaneously maintaining its 0% funds rate. It was not until Dec. 2015 that the Fed finally decided to raise the funds rate, citing improvements in economic growth and employment that would begin to create inflationary pressures. The Fed signaled that this was the beginning of a different era, anticipating four rate increases in 2016.

Inflation never arrived. Instead, the announcement from the Fed sent markets across the globe tumbling. The S&P 500 declined 11% before its mid-February trough, and the Shanghai Index fell to its seven-percent automatic stop multiple times during the first week of January. With so much market volatility the Fed knew that a first-quarter rate raise was impossible, so it maintained its current rate. But this still left three opportunities to raise rates this year, and the Fed continued planning to do so. However, changes in the U.S. economy have once again forced a rate freeze. Growth was expected to be anemic in Q1. A report released by the Department of Commerce on April 28 confirmed this, stating that the domestic economy grew at a .5% annualized rate. This news, when combined with the continued glut in labor force participation which is near a thirty-year low and an increasingly strong dollar has ensured a continued change in the Fed’s original plans for this year.

So when will rates finally rise? The Fed controls the funds rate, and consequently the money supply. When the economy is in recession, the Fed inflates the money supply, lowering interest rates and encourages lending, putting idle resources to work. By contrast, when the economy is booming and near full production, the Fed raises interest rates to discourage excess lending and spending. This also slows the economy, preventing overproduction and inflation. The key indicator the Fed is watching for is increasing inflation. Yet, even as the U.S. economy approaches full employment, inflation has barely increased. The Fed knows that it will have to raise interest rates eventually because leaving interest rates excessively low for too long can have a negative effect on investment behavior and, therefore, economic activity. Until it becomes clear that inflation is occurring and the economy has approached its production capacity, the Fed will continue to be cautious about increasing rates in an unstable post-recovery United States.

In order to spur inflation, consumption must increase. Consumer spending accounts for around 70% of U.S. GDP, and is therefore the primary driver of economic growth and inflation. While most economic indicators have recently strengthened, consumers are still not spending enough to cause inflation. The U.S. consuming class has recovered feebly from the recession thanks to the stagnation of wages and increasing income inequality. If the economy is to reach the levels of production required for the Fed to begin its rate increase program, consumer spending will have to increase. In order for spending to increase, more money must be put in the pockets of average Americans.

The eventual goal of maintaining low interest rates is to transfer capital to consumers and entrepreneurs, thereby increasing spending and generating economic growth. But the Fed only has the policy scope to attempt this through the channels of the modern banking and finance system. The last eight years of economic recovery have shown this method to have many flaws. Only a targeted fiscal policy from the government could directly inject money into the economy and stimulate growth. With the crumbling state of U.S. infrastructure, a large-scale infrastructure spending program could be one way to rapidly increase wages for millions of Americans, giving them greater consuming power. The U.S. government could also simplify regulations, steering away from micromanaged details and adding sunset clauses, in order to increase competition and allow new firms to compete. This would make the market more dynamic and encourage an increase in wages. Finally, an expansion of the Earned Income Tax Credit program which effectively gives poor families cash if they fall below a certain income level has been lauded as one way to increase spending for low-income families.

Even with this change in Fed policy, the predictions are not bleak. Even though GDP growth was weaker than estimated in Q1, the same problem has occurred the past two years. Even with disappointing Q1s, growth rebounded and ended in both years with the same predicted overall GDP increase. The United States is reaching full employment (which the Fed says occurs when unemployment is at five percent), labor force participation is beginning to increase, and wages are starting to rise. Economists remain hopeful that the economy will rebound, especially with the anticipated rise in consumption during the coming summer. The economic recovery has occurred and the United States is in a much stronger position today than it was in 2008. But this does not mean that millions of Americans have not been left behind and are still struggling to join the rest of the nation, their voices being heard in the throng of Bernie Sanders and Donald Trump supporters. It is imperative that the U.S. government put aside partisan politics and create a policy-based economic solution. Only then can we be sure that the recovery is over.

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