Fed minutes set stage for rising interest rates in 2017
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On Wednesday, the Federal Reserve released minutes from the Federal Open Market Committee’s most recent meetings, which occurred on Jan. 31 and Feb. 1, respectively.

The minutes show that both short- and long-term interest rates will be moving up over the next few years, which will make it more expensive for American consumers to borrow, but will benefit savers.

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The Federal Open Market Committee (FOMC) is the Federal Reserve’s monetary policy-making body; it sets short-term interest rates to meet its dual mandate of price stability and maximum, stable employment.

  

According to the meeting minutes, the FOMC believes it is making progress toward these goals. Inflation has been below the FOMC’s 2 percent target (measured using the personal consumption expenditures price index) for years, the result of significant slack in the economy that has limited the ability of businesses to raise prices.

In addition, weak wage growth, a strong U.S. dollar and the big drop in energy prices from mid-2014 to mid-2016 have all contributed to the tepid inflation numbers.

But with energy prices rising over the past half-year and wage growth picking up as the job market tightens, inflation is moving toward that 2 percent target.

The minutes state that, “Information on inflation received over the intermeeting period was broadly in line with participants’ expectations and was consistent with a view that PCE inflation was moving closer to the Committee’s 2 percent objective.”

The second part of the dual mandate is more difficult to define because the unemployment rate associated with “maximum and stable employment” can fluctuate over time.

According to the minutes, “at 4.7 percent in December, the unemployment rate remained close to levels that most participants judged to be consistent with the Committee’s maximum-employment objective.”

The unemployment rate moved up to 4.8 percent in January, but that type of month-to-month fluctuation is normal and doesn’t change the overall labor market picture. The FOMC also looks at other labor market indicators, and according to the minutes, they also show a job market that is close to full employment.

The minutes say that the job market should continue to improve: “Most participants still expected that if economic growth remained moderate, labor markets would continue to tighten gradually, with the unemployment rate running only modestly below their estimates of the longer-run normal rate.”

It may not be at the committee’s next meeting — March 14-15 — but the fed funds rate will be moving up this year, almost surely more than once. Some FOMC members were more concerned about remaining unemployment and underemployment, but this was a minority view.

The FOMC’s key policy tool is the federal funds rate, which is the interest rate on overnight loans from one bank to another. With the economy stuck in dire straits during and after the Great Recession, the FOMC cut the fed funds rate to close to zero and held it there for roughly six years.

The FOMC raised the rate by a quarter of a percentage point at the end of 2015 and again at the end of 2016, bringing it to a range of 0.50-0.75 percent, still far below its long-run average.

With inflation expected to move toward 2 percent and the job market close to full employment, the FOMC is preparing for further interest rate increases.

The minutes say that, “many participants expressed the view that it might be appropriate to raise the federal funds rate again fairly soon if incoming information on the labor market and inflation was in line with or stronger than their current expectations.”

In layman’s terms, this means that people should get ready for higher interest rates. It may not be at the committee’s next meeting — March 14-15 — but the fed funds rate will be moving up this year, almost surely more than once.

If the economy continues to grow in 2018 as expected, rates will go up next year as well. PNC expects the fed funds rate to be above 2 percent by the end of 2018, consistent with Fed projections.

This means higher borrowing costs for households. Interest rates on credit cards and shorter-term loans, like home equity lines of credit, have already been increasing as the fed funds rate has moved slightly in recent years.

A higher fed funds rate will also boost costs for auto loans, particularly ones with shorter payback periods. However, short-term interest rates will only increase gradually, much slower than in previous expansions; this should limit the fallout for borrowers.

Due to big structural changes in the economy over the past few decades, interest rates in the future should be much lower than they have been in the past.

Mortgage rates, particularly longer-term ones, are less responsive to fed funds rate hikes, but those have been moving up as well — especially since the presidential election — because of higher expected inflation and projections that show more federal borrowing as budget deficits rise.

Mortgage rates will continue to increase over the next few years, raising the cost of homeownership and gradually taking some of the steam out of the housing market. But rates won’t move up quickly enough to cause another housing market crash. They will remain well below their earlier highs.

While borrowers will pay more in interest, savers will get better returns on their investments. One of the complaints about the Fed’s ultra-low interest rate policy is that it has hurt households, many of them retirees, who have a lot of money in bank accounts, certificates of deposits, and bonds.

Higher interest rates will boost returns on these investments, giving savers more money to spend.

 

Augustine Faucher is the deputy chief economist at PNC Bank. 


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