Understanding the FED. What’s all this about Interest Rates??
By: Matt Mulholland
Tags: Interest Rates, Federal Reserve, Data Visualization

The United States Central Bank (FED) has the ability to raise and lower interest rates. Interest rates have a profound and far reaching effect on the economy and, recently, FED Chairwomen Janet Yellen made her address to Congress and talked about the potential of the FED beginning to ‘normalize,’ that is to say raise, interest rates before the end of 2015, possibly in the summer. This data-story aims at clarifying some of the different considerations the FED takes when choosing whether or not to raise interest rates and why, in particular, they are not raising them, yet.

While other indicators and influences in the economy have appeared to improve, inflation has remained sluggish over the past 2 and a half years. Inflation reflects an active economy. When people have more money, when they feel more optimistic about the economy, they start to spend and the increased demand will start to raise prices. So when the FED sees lower inflation than their 2% annual goal, it causes them to pause and think twice about raising rates.

If the FED were to raise interest rates it would without any doubt lead to even lower inflation. Raising interest rates causes liquidity in the market to decrease, leading to lower spending, leading to lower inflation. The less than ideal inflation over the past few years is probably the best explanation for why the FED has not raised interest rates up until this point.

Most anyone will tell you that a good indicator in the economy is unemployment. The normal unemployment that is reported on regularly in the media and the oval office is U3. But, as you can infer from this graph, it is not the only way of measuring unemployment. U6 is another such way and it is calculated by taking U3 and adding to it workers who are in part-time work that would like a full-time job.

Normally, the majority of people would be satisfied with the standard measure of unemployment, but during the financial crisis, the number of people who were pressured into part-time work rose relative to the people who were completely without work. This led to a small debate on whether or not U3 is a good indicator of the current job market because it failed to take into account this uncharacteristically high U6. Notice how the ‘Difference’ line, which shows the difference between U6 and U3, rose at the end of 2008 and has not returned to pre-recession levels.

When the FED looks at unemployment, they are optimistic looking at U3 but will pause when looking at U6. All this being said, it is important to remember that unemployment is a lagged indicator. In other words, the economy might have improved but it can take time for that improvement to be reflected in unemployment because hiring is not instantaneous.

To take another view, Yellen recently met with a more conservative group who would like to see the rate raised sooner rather than later. By keeping the interest rates low for so long, it has actually begun to hurt employment rather than helping it. When capital has been as cheap as it has been, it makes it more likely that business can invest in physical capital rather than more employees. The firms are likely to take out a loan and buy a machine to do the work because they will never see loan interest rates so low after the FED acts. Add this to minimum wage hikes and companies like Mcdonalds are much more likely to hire a touch screen payment system rather than a cashier.

Wage growth is similar to unemployment in what it says about the economy but not the same. A tightening labor market, meaning more and more people have jobs, will result in higher wages as employees can start to ask for more money as the scarcity of their skills increases. For the past 4 or 5 years, wage growth has hovered around 2%, barely keeping up with inflation. Wage growth is one of the key indicators that continues to lag, resulting in the FED being ‘patient’ about raising interest rates. If the data for 2015 start to show more substantial wage growth, we can be much more confident about normalization occurring before the year’s end.

This graph shows the US Labor Force Participation Rate. The rate is now the lowest it has been in over 3 decades and many people are unsure of the cause. One of the main explanations going around is that the baby boomers are starting to retire. This could account for some of the decline but not all. The long term effect of more and more people not working on the American economy could be drastic. As more and more people go on welfare or other government subsides it could seriously dampen the long term finances of the nation. A lagging LFPR is yet another reason why the FED decided to not raise the rates just yet.

Interest and bond prices have an inverse relationship. When the FED lowers interest rates, what they are really doing is buying bonds with newly printed money. So instead of there being a piece of debt floating around in the market (the bond) there is new money. The FED starts buying bonds, the increased demand causes bond prices to go up which in turn makes interest rates go down because of the aforementioned relationship.

This is why the FED Balance Sheet looks like it does above. The longer that the FED continues to hold interest rates down, the more debt they will accumulate. This amount of debt has never been seen in the FED’s history and it has raised questions about the risks associated with a central bank holding so much debt. Many wonder if there will be long term consequences if the FED does not curb their current intake of debt.

Take Away

Many different factors affect when the FED will finally raise rates. Without a doubt, it is getting closer to doing so, but if certain factors of the economy do not improve this and the next period (Q1 and Q2 2015) they could postpone it even further. The most important incoming data to watch will be wage growth and inflation. When these factors in particular start to normalize the FED will begin to raise interest rates.

Last Updated: March 4, 2015 ; Data Source: BLS, FED.