Why Raising The Federal Funds Rate Today Is A Bad Idea

Many forecasters expect a rate increase today, and indeed it may happen, but predicting the actions of a group of economists (the FOMC members) is not as easy as forecasting the actual economy. Thus, anything could come out of the Open Market Committee meeting today.

However, the economy does not seem to need a rate increase at this time. Indeed, a rate increase can create a potential damage to an already soft economy.

The Yield Curve Doesn't Need Flattening

One of the best instruments for understanding the rate policy in the U.S. is the U.S. Treasury yield curve. Between November of 2016 and March of this year, the yield curve steepened with the 10 and 30 year rates advancing sharply.

This steepening of the yield curve presented a danger for the economy and the Fed had to act to reduce the long-term rates by increasing the short-term rates. When the Fed increases the federal funds rate, it decreases long-term inflationary expectations, thereby putting pressure on the long-term rates to decrease.

However, in the last two months, the long-term yields came down substantially, and are now in line with the new long-term equilibrium. Thus, a rate increase at this time is unnecessary and should not be done.

Back in 2013, I argued that the economy moved into a new long-term equilibrium with low long-term interest rates. In 2013, I forecasted the 30 year rate to remain around 2.75 – 3.4% for the foreseeable future.

The accuracy of my 2013 forecast landed me an appearance on CNBC’s Closing Bell in May of 2014. In that show, I stated that we are in a low rate environment on a permanent basis. My view has not changed since then.

Low Long-Term Rates And Inflation Expectations

The long-term interest rates are a function of a number of factors. These include factors affecting inflation and inflationary expectations, marginal productivity of capital and other factors in production, etc.

One of the key driving forces behind low real long-term interest rates has been the technological progress. The technological progress has stimulated capital formation and in the process reduced the marginal productivity of capital.

This gradual and slow process has moved us from long term real rates of about 3% to roughly 1% within a quarter of a century.

The inflationary expectations have also been rather modest. Growing productivity, globalization, and reduced growth in the Western economies due to regulatory and tax burdens have all contributed to a lower inflationary environment.

Together with the low real interest rates, this is responsible for the observed low nominal long-term rates.

Addicted To Low Rates

The situation is also made more complicated by the addiction of the U.S. economy to low interest rates. Our capital and real estate markets have become very sensitive to small changes in long-term interest rates.

To an extent, the softening of the U.S. economy we have been observing over the course of the last three months has been induced by the steepening of the yield curve between November and March.

All of this suggests that long-term rates will likely remain low for the foreseeable future and there is presently no need for a rate increase to flatten the yield curve. In fact, it is unlikely that there will be a need to do this in the remainder of this year.

No Threat To The Dollar

Economically speaking, one of the greatest threats to the US economy, which could fundamentally change the rate outlook, would be the loss of the international currency status of the U.S. dollar.

Presently, the dollar is the currency used to trade all commodities on Earth. If that ever were to change, the inflationary outlook for the US would rapidly change.

Luckily, presently nor on the horizon, there are no competitors to the dollar, making such threat unlikely.