The U.S. Federal Reserve: Why Do They Raise Rates… or Not?

As published in IASBO December Newsletter

At least eight times a year the U. S. Federal Reserve (Fed) Board of Governors gathers to discuss the current state of the U.S. economy. At these meetings, the Federal Open Market Committee (FOMC) also decides if the key interest rates the Fed controls should be adjusted. These discussions and decisions can have a large impact on of the cost and availability of money and credit in the U.S. banking system, which in turn impacts the growth of the economy. This article highlights some of the key factors the FOMC considers when they gather to make a decision about the future direction of interest rates.

The Fed was created back in 1913 by an act of Congress to promote security and stability in the U.S. banking system after a number of “runs” and bank failures occurred due to a decentralized and unregulated structure. In addition, in 1935 Congress passed the Banking Act which established the FOMC as the Fed’s monetary policymaking body and gave the Fed the ability to set and control certain short term interest rates such as the Federal Reserve Funds Rate. To set these interest rates, the FOMC must continuously consider many factors.

The FOMC is charged with setting interest rates to promote stable inflation, full employment, and a stable financial system. A key factor in the FOMC’s interest rate decision is their assessment of the current and future inflation prospects. Runaway inflation can have very adverse economic effects and may take years to recover from. This occurred in the U.S. in the 1980s and more recently has been detrimental in emerging market countries like Argentina and Venezuela. Therefore, if the FOMC believes inflation is rising rapidly or reaching a level above their targets, they will typically decide to increase interest rates in an effort to slow inflation and promote stability.

The Fed’s interest rate decision process also considers the current and future growth outlook for the U.S. economy. Growth is influenced by many factors including consumer and business spending, government spending, and trade (imports and exports) with other countries. Consumer spending makes up nearly 70% of the U.S. economy so consumer activity is critical to monitor. A stronger consumer can potentially withstand higher interest rates, while a weakening consumer outlook might prompt the FOMC to hold or even cut interest rates. To assess the consumer outlook the Fed considers trends in a number of economic indicators including the unemployment rate, wages, hours worked, housing prices, debt levels, and retail spending.

While the Fed is primarily focused on activity in the United States, they must also take into account how global economies are performing, and how global central banks could influence the outlook for the U.S. For example, Canada, Mexico, and China are the U.S.’ largest trading partners, and if their economies weaken that could have an impact on the future growth outlook for the U.S. economy. In addition, foreign central banks and their rate setting process can influence where global investors choose to invest. This can impact the growth prospects for our economy if investors view investment in other countries as more attractive opportunities. So in short, while the Fed is focused on stabilizing the U.S., to do so, they have to be aware of how the global economy and central banks are performing.

Finally, the Fed also considers what stresses may be occurring in the banking and financial systems when setting interest rates. The most recent example of this was during the financial crisis of 2007-2008 when the FOMC lowered interest rates ten times during that period to nearly 0%. While this was an extreme event, it demonstrates how the Fed can respond to stresses in the financial system. The health of the banking system is critical to the successful implementation of the FOMCs interest rate decisions.

The U.S. is the world’s largest and most complex economy, influenced by many factors that cannot be directly measured. As is probably clear from this, the FOMC’s process for setting interest rates at the “right” level is not an exact science. It can even be plagued with potential measurement and forecasting error. However, the Fed’s process to set interest rates is the most sophisticated and comprehensive process in the world. While not perfect, investors, consumers, and business managers should have confidence that the process is effective in managing short term interest rates in the U.S.


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