Staying Track: The FOMC And Interest Rate Liftoff

by: The Intercollegiate Finance Journal

By Dean Murphy

The Federal Open Market Committee (FOMC) - the economic brain trust that determines the course of monetary policy in the US - is now faced with another integral policy-making decision, so soon after responding to a systemic financial crisis that threatened to debase the U.S. and the world economy. The issue at hand has more to do with previous measures taken by the FOMC than it does to prototypical debate surrounding the strength and progress of the U.S. economy. A fundamental question regarding the timing and scope of interest rate increases has become the point of contention among the economists that compose the FOMC.

While the FOMC announced last year that it intended to begin a process of returning to conventional, pre-recession monetary policy, which includes a gradual increase in the Federal Funds Rate (FFR) - the U.S. economy's baseline interest rate - several important events have surfaced both domestically and abroad. Oil prices have plummeted to under $50 a barrel, inflation has consistently run below its ideal level, labor slack is still perceived to plague the domestic economy, and downward economic trends in the Eurozone and several other areas have threatened economic contagion.

Each of these external factors contributes to and is normally associated with decisions that promote accommodative monetary stances, such as lowering the FFR or purchasing large amounts of financial assets. However, recent commentary and public statements from various FOMC members indicate that the subject of interest rate hikes has not produced a uniform consensus within the monetary authority.

Economists who view inflation as a sometimes necessary or positive influence - doves - contend that raising rates too soon will inevitably hinder already sluggish economic growth by cutting off access to cheap capital. The opposition - hawks - retorts that remaining at the lower bound for a prolonged period will contribute to a possible bout of rampant inflation.

Despite the negative economic news and oftentimes heated disagreement that emanates from committee meetings, the FOMC press statements continue to maintain that it will remain "patient" in its decision to raise interest rates and has yet to produce indications that it will drastically stray away from an inevitable rate hike in the near term.

What justification is there, then, that has led the FOMC to a normalization stance that has changed so little in light of substantial setbacks to its intended goals of price stability and maximum employment?

One of the primary factors driving the push for rate hikes centers around the consequences of maintaining extended periods of abnormally depressed interest rates. The most recent and evident example of the effects stemming from prolonged low interest rates is the events leading up to the 2008 financial crisis. Following the "Dot Com" mania of the early 2000s and a swift recession-neutralizing response from the Fed, interest rates were kept at historically low levels, even in the aftermath of the downturn. Years of low rates encouraged a booming housing sector, low security yields, and a subsequent hunger and tolerance for higher-return, riskier investments. This process was partially responsible for the housing finance debacle that was the largest economic and financial downturn since the Great Depression.

Considerable gains in the US equities market have left open the question of whether staying in the zero lower bound has encouraged an analogous situation nearly seven years later. The ability to borrow at substantially low rates has the ability to promote "irrational exuberance" in the markets. Easily accessible credit has the potential to produce unfounded overvaluations of various stock prices.

The complex equation relates more so to the public's perception of the FOMC and its credibility as the ultimate monetary policy institution. The Federal Reserve and the FOMC both have endured their fair share of external criticism over the course of the past several years. After launching several massive rounds of asset purchases that totaled over $3 trillion, the Fed's 2% core inflation target has yet to fully materialize. Political crusaders have openly called for legislation to tighten Congressional oversight of the Fed and to gain the authority to audit the FOMC decisions.

Unrealized promises and public campaigns aimed at incorporating more politically based procedures into the monetary policy decision-making process have greatly undermined the Federal Reserve and FOMC's credibility with the general public and diverse actors throughout the economy. In order to more effectively fulfill both sides of its dual mandate of price stability and low unemployment, the Federal Reserve must first be able to secure the trust of the public and maintain the perception that it can reach these goals with its proposed open market operations and various other tools.

While the presence and influence of dovish members far outweigh the hawkish minority, the FOMC will not protract its currently proposed range of dates for the increase of interest rates, which is the latter half of 2015. Historic lessons from our recessionary past, coupled with plausible public backlash toward constant policy adjustment or reversal, are sufficient to lock in the interest rate liftoff in the near future. Indeed, if the FOMC does not raise rates with an appropriate time frame, the U.S. economy may bear witness to further stagnation and instability, if not outright recession.