Yesterday the U.S. Federal Reserve raised interest rates for the first time since 2006. There has been much hand wringing in the financial markets in anticipation of the event, but what does it mean for the Fed to raise rates?
The rate that has been changed is the Federal Funds Rate, which is the rate banks pay to borrow money from other Federal Reserve member banks overnight in order to manage the amount of money (reserves) they hold at the Federal Reserve. Each institution has a required reserve level, and if their reserves rise above the required level, they can lend the excess to another institution whose reserves may have fallen below the required level. When the Fed Funds rate is low, banks may be more willing to make loans, which increases their required reserves, because the cost of borrowing their reserves is low. As the rate increases, banks may make fewer loans, and this can put a damper on economic activity.
This rate increase will likely have little impact on the economy, given its size (only 0.25%), but there could be additional rate increases over the next year or more. Janet Yellen, the Federal Reserve chairman, stated “the underlying health of the U.S. economy seems to be quite sound,” at a press conference. The Fed is interested in bringing interest rates to a more normal level both to ensure that economic activity doesn’t overheat and to provide more wiggle room to adjust rates if the economy weakens in the future.
There are forces at work that could limit the level to which the Federal Reserve will increase rates. While unemployment has declined to only 5%, underemployment (people who would prefer to work more hours) remains persistently high at 9.6% of the labor force, excluding the unemployed. Inflation has also been a tough nut to crack. We baby boomers grew up afraid of the return of the double digit inflation that plagued the country in the early 80’s, but now we are in a new era. Inflation has remained uncomfortably low since the recession ended in 2009. A healthy pace of inflation acts as grease for the economic wheels. Just as an ungreased wheel may turn more slowly, low inflation can lead to lower economic growth. Wage growth and spending may stagnate, and debt repayment is more costly without inflation to eat away at the value of the debt.
Masaaki Shirakawa, a former Bank of Japan (equivalent to the Federal Reserve) governor diagnosed the cause of the chronic deflationary, low growth economy in Japan as being a shrinking labor force and declining labor force productivity. Japan’s median age is over 46 and 39% of the population is over the age of 55. His theory is that interest rate changes, and other central bank activity, are less effective in boosting economic activity than they were in the past due to the downward pressure of an aging demographic. Older people simply buy fewer things. Shirakawa also warned that the U.S. and Europe were destined for a similar fate.
He may be right. We have seen that the Federal Reserve’s actions to boost the economy have had less impact than the Fed itself predicted. While not as old as the Japanese population, our population is getting older. The median age in the U.S. is 37 and 25% of the population is over the age of 55. With baby boomer retirements increasing, the labor force participation rate (the percent of the population that is actively working or seeking work) has dropped to less than 63%. Labor force participation peaked at 67% in the late ’90s, and leveled off at 66% through 2007. But since the recession, it has been on a steady decline, with the improving economy doing little to entice people back into the labor market. In addition to declining participation rates, labor force productivity has been anemic. Productivity growth (measured by output per hour of labor) has languished at less than 1% for four years running.
Due to our own demographic pressures, we are unlikely to see a substantial increase in economic growth which would relieve the underemployment issue and stoke inflation. As a result the Federal Reserve will see little need to substantially increase interest rates going forward. Rate increases in Europe were quickly reversed after having an adverse impact on the European recovery from the recession. The median Fed Funds rate over the last 25 years has been about 3.0%. We probably won’t be seeing those rates any time soon.