When to raise rates: the Fed's exquisite dilemma

There is no inflationary pressure, which makes it hard to justify tightening policy

Monetary policy, in as much as it relates to the setting of interest rates, is often thought of as the counterpart to inflation. High rates are used to quell demand when prices rise too fast; low rates to incentivise spending when prices stagnate or fall.

But recent debates on whether or not interest rates should rise – at a time when, the Financial Times notes, the world is "singularly short of inflationary pressure" – show there is much, much more at stake.

The Federal Reserve's rate setting committee has two more meetings scheduled for this year, in October and December. Its chairman Janet Yellen, along with other senior figures continue to assert that it will vote to raise rates at one of those meetings. 

Inflation remains near zero. Amid floundering commodities prices and slack demand in emerging markets, it is evidently going nowhere fast. So why might the Fed decide to lift interest rates later this year?

Last week, Yellen told an audience at the University of Massachusetts that any decision to increase rates would be driven by long-term goals. Among her key considerations, according to The New York Times, is the fact that "inflation in the long term [is] determined by public expectations" and the belief that as the domestic economic recovery takes hold, inflation will return to the two per cent target.

Essentially this is the argument that rates need to pre-empt a build in price pressure, with wages finally rising slowly and unemployment at a seven-year low. To do otherwise, risks having to play a dangerous game of catch up.

Set against this financial landscape is the fact that the US does not exist in isolation. As Bloomberg notes, the Fed said that when it voted to hold rates earlier this month it was watching an apparent slowdown in China closely for signs it would hit exporters and other companies and thus wreak havoc at home. 

"The question is whether or not there might be a risk of a more abrupt slowdown than most analysts expect," Yellen said.

Another consideration is the International Monetary Fund, which warns, says The Guardian, that emerging economies could face a fresh "credit crunch" as policy is tightened, after gorging on cheap debt over the last few years. 

But perhaps this is the strongest case yet for lancing the boil. The Bank of International Settlements recently warned against keeping rates low simply for fear of rocking an apple cart that's stacked too high on the back of low rates. 

This feeds into a wider view that the low rate environment has created "distortions", as private and corporate investors find themselves forced to become increasingly creative in the search for yield and to become incentivised strongly against saving. Asset bubbles in property, for example, are the result.

Yellen and her colleagues appear to be convinced of the merits of the argument that rates will have to be normalised sooner rather than later. That doesn't make the choice to do so any easier.

For more information on investments, please click here


The Omicron threat
An image of Santa Claus at a Christmas Market in central London
Why we’re talking about . . .

The Omicron threat

Investing in Asia: what the experts think
Vietnam: ‘set for a big leap’
Expert’s view

Investing in Asia: what the experts think

Ryanair: readying for departure from London
Ryanair CEO Michael O’Leary 
In Brief

Ryanair: readying for departure from London

Tesla joins the $1trn club 
Hertz has ordered 100,000 Tesla Model 3s
Business Briefing

Tesla joins the $1trn club 

Popular articles

Is World War Three looming?
Xi Jinping
In Depth

Is World War Three looming?

Is Boris Johnson’s authority ‘evaporating’?
Boris Johnson
Behind the scenes

Is Boris Johnson’s authority ‘evaporating’?

Vladimir Putin and his mysterious love life
Vladimir Putin and his now ex-wife Lyudmila Putina

Vladimir Putin and his mysterious love life

The Week Footer Banner