Resolved: The Federal Reserve Should Raise Rates

The United States Federal Reserve Bank (the "Fed") is the apolitical institution that is in charge of controlling the monetary policy of the United States, doing so with three main tools: the reserve requirement, the discount rate, and open market operations. The latter of those tools is the most unique, mainly because it is controlled by the Federal Open Market Committee (FOMC), a special committee comprised of leaders of the Fed across the nation that makes decisions about where they think the Federal Funds rate should be according to current economic conditions. The Federal Funds rate is the prevailing rate in the United States that is the base for many other interest rates including, but not limited to, bond yields and interbank overnight loan rates. The Fed controls interest rates using open market operations, which at its most basic is the buying or selling of government bonds in an effort to either expand or contract the money supply, respectively. In a world where everything has a price, so does money. Normal assets are valued using money as the common base, but the price of money is actually interest rates. In this respect, money acts like any other good or service in that its price, interest rates, are a function of supply and demand. When the Fed buys bonds through open market operations, they are giving people money for their bonds which functions to expand the money supply. This could be represented in a simple supply and demand graph as a rightward shift to supply, which drives down prices, in this case interest rates. Because money is the base for all other goods and services, increasing the money supply not only decreases the price of money, but increases the price of all other goods due to the reduction in price, and therefore purchasing power, of money itself. The Fed uses open market operations to control interest rates in order to help keep the economy healthy, or to improve it when it is not. In times of economic turmoil, like in recessions, the Fed will lower interest rates in an effort to encourage investment spending, characterized by purchases of long term plant assets and usually financed with loans whose cost is based off of the interest rates that the Fed sets; encourage exports through a weaker dollar; and discourage saving, which can be characterized by keeping money in banks, and thus not changing hands in business transactions that increase consumption spending. All these effects of lower interest rates have the effect of increasing the factors that contribute to Gross Domestic Product (GDP), and thus have the effect of increasing GDP itself in hopes of leading to economic expansion again. In times of a bustling economy rates will be risen in order to control inflation and prevent bubbles in certain markets from forming, which can lead to recessions if "popped", like the housing market bubble did immediately preceding the past recession. While the basis behind controlling rates appears simple in theory, in practice the challenge is not whether to raise or cut interest rates, but when to raise or cut them, and by how much. Changing interest rates is a game of momentum. When interest rates are already falling, it is easy to keep cutting them, as that is what the public expects. Switching between expansionary and contractionary policies, however, is very difficult because it causes uncertainty which inherently hurts the economy as investors do not have confidence when they are not certain what will happen. A change in monetary policy requires careful attention to macroeconomic indicators in order to make sure the timing is right, as changes in interest rates in either direction have costs and benefits. In the case of the current decision in front of the Fed, the situation is further complicated by negative economic outlook in foreign markets, and confounding factors that drive the macroeconomic indicators. Currently, the most important macroeconomic indicators driving the debate on whether to raise rates or keep them low are unemployment and inflation. In this debate, I aim to focus on why the Federal Reserve should not raise rates within the next six months. As an overview of current U.S. macroeconomic indicators, currently inflation, as measured by the CPI in percent YoY, is at 0%. Unemployment is at 5.1%, with the Natural Rate of Unemployment (NRUE) at 5.06%, which is the rate of unemployment predicted when the economy is at full capacity. The unemployment figure actually therefore looks promising, as unemployment is extremely close to its natural rate. The biggest reason for raising rates at this point in time is due to inflation. Normally, after extended periods of low interest rates, the Fed will raise rates in order to fight inflation. The reason inflation becomes a problem is that the Fed keeps interest rates low by buying bonds in the open market, which functions to increase the money supply as people are receiving money for their bonds, which in turn causes inflation. Inflation is currently at 0% though, which is dramatically lower than the Fed's target rate of 2%. Currently, the domestic economy is not functioning at its most efficient capacity. Industrial production has recently decreased by .2% MoM showing a decrease in demand for industrial goods and commodities, and has a net negative effect of GDP. Another indication of domestic business performance is Business Inventories, which have increased by $700 million since last month indicating that there has been a decreased demand for goods relative to what businesses had anticipated. Retail sales increased .1% MoM, missing economist estimates of a .2% increase which shows that consumers are simply spending less money. All of this considered, I now turn to theoretical economic analysis to estimate the impact of an increase in the FFR. Increasing the FFR means that interest rates for debt will also increase. This will make Investment Spending, one of the four components of GDP, decrease because it will make investments, like purchasing a car or a home more expensive, more expensive as a result of interest expense. Increasing the FFR will also increase the yields on treasury bonds, short term bonds affected most directly. Short term bonds like the 3 month, 6 month, or 1 year treasury bill act as the domestic "risk-free rate", which is the basis for valuing currency foreign exchange rates. All else equal, If U.S. "risk-free" bonds increase in yield, more foreign investors will seek to purchase them, which is done by exchanging their currency into USD and then purchasing the bonds. This will increase the demand for USD, thus increasing the price, as represented by stronger exchange rates with foreign currencies. A stronger USD means exports are more expensive since U.S. goods are more expensive relative to foreign goods, and imports will be cheaper because foreign goods will be cheaper relative to domestic goods. This will have a net effect of decreasing net exports, another factor of GDP. Since consumption spending is generally cyclical and not a function of interest rates and government spending is controlled by fiscal policy (consumption spending and government spending being the other two factors of GDP along with investment spending and net exports), all else equal, an increase in the FFR will decrease domestic production as measured by GDP. This, in conjunction with the previous review of current business indicators, does not make for a compelling reason to raise interest rates since raising interest rates will stunt the already lagging domestic economy through decreasing domestic spending. A stronger USD will also cause domestic corporate profits to fall as there is a decrease in exports, which will most likely lead to employees getting laid off, increasing the unemployment rate that is already so good. Besides the domestic economy, the Fed also has to consider foreign influences. China has recently been undergoing a fundamental change from a state-backed, industrial based economy to a market-backed, consumer based economy. This has resulted in their manufacturing output decreasing, representing a fall in demand for commodities worldwide as China is the primary purchaser of commodities, which serve as industrial production inputs. This, along with their recent devaluation of the Yuan, has caused a great amount of uncertainty about the Chinese economy, causing theirs and our equity markets to crash in August. Foreign market volatility and uncertainty would be exacerbated by an increase in the FFR, which already causes investor uncertainty, and most likely result in a large market correction that the Fed is worried about. The FOMC's long run goals and monetary policy strategy are defined by the Fed as "The Federal Open Market Committee (FOMC) is firmly committed to fulfilling its statutory mandate from the Congress of promoting maximum employment, stable prices, and moderate long-term interest rates" (http://www.federalreserve.gov...). In its effort to promote maximum employment (the unemployment rate equal to the natural rate of unemployment) and stable prices (inflation equal to 2%), it is not currently in the interest of the Fed to raise the FFR as I have shown that an increase in the FFR will have a negative impact on unemployment, and reduce inflation even further, going directly against the goals of the FOMC. "Should" is defined by Merriam-Webster as "used in auxiliary function to express obligation, propriety, or expediency" (http://www.merriam-webster.com...). If "should," as in the title of the resolution "The Federal Reserve Should Raise Rates," implies an obligation of the Fed to raise rates, then this would just be simply contradictory to the main goals of the FOMC, and thus false a false statement.