The Fed’s Unwarranted Skittishness
History shows that fears of slowing the economy with an interest-rate increase are overblown.
The Federal Reserve has forecast sustained economic growth when it raises the federal-funds rate. Yet in 2013-14, even before ending asset purchases under its third round of quantitative easing, the Fed expressed concerns that a one-quarter percent rate increase could sidetrack the economy. And this year the Fed has said that a stronger dollar would harm the economy. Are its fears warranted? Recent history says no.
Since the early 1980s there have been five episodes when the Fed raised rates. Economic growth remained steady or accelerated during every one of these rate-increase cycles. The initial rate increases were a reflection of the improving economy.
In mid-2004 the 1% fed-funds rate was below inflation, and in early 1994 the 3% rate was barely positive in real terms. When the Fed raised rates in these instances, the availability of credit or the growth in the money supply was not interrupted. Instead, according to the Federal Reserve’s data, bank lending to households and businesses continued to grow solidly.
During the five rate-increase cycles the dollar sometimes weakened versus major currencies (2004-06, 1994 and 1987-89) and sometimes got stronger (1983-84 and 1999-2000). In general, rising interest rates did not change the broader trend in the dollar. This makes sense: The value of the dollar reflects and is influenced by an array of factors, and monetary policy is only one.
The only case when the Fed’s rate increases seemed to change the dollar’s trajectory was in 1994, when the positive economic response was a catalyst for dollar strengthening. In those rate-increase cycles when the dollar did get stronger, U.S. exports remained strong, reflecting global economic trends. Present global economic conditions are somewhat less favorable than before prior Fed rate increases, but U.S. consumption and domestic demand growth is healthy.
The Fed has made mistakes when it allowed international concerns to influence monetary policy. In 1997-98, U.S. economic growth was strong and the unemployment rate was below 5%. But the minutes of the Fed meetings suggest that Fed worries about the potential fallout from the Asian financial crisis and Russian default led it to delay raising rates. Strong growth persisted and the stock market skyrocketed. The Fed raised rates too late in 1999 and then tightened money too much in 2000. A mild recession followed.
In 1987 the Fed’s attempt to prop up the dollar by aggressively hiking rates generated fears that if the dollar did not respond, further rate increases would harm the economy. This contributed to that year’s stock-market crash in October.
Long-term bond yields rose in each of the five rate-increase cycles since the early 1980s, but always by less than the increase in the fed-funds rate. The flatter yield curve reflected lower inflationary expectations. The U.S. stock market has always maintained its prior year’s gains or rose further after the Fed increased interest rates. Profits rose with the sustained economic growth while price-earnings multiples receded.
The economy remained strong during and after the rate increases of 1983-84 and 1994—yet the Fed did not warn markets that it would raise rates. In both cases, the economy benefited from favorable economic policies.
In the 1980s, these favorable policies consisted of the Reagan administration’s tax cuts, investment incentives and the market’s confidence stemming from lower inflation. In the 1990s, the economy benefited from the bipartisan North American Free Trade Agreement that came into force in January 1994, and the deficit-reduction legislation negotiated by the Clinton administration and Congress in 1993.
When the Fed did raise rates in those instances, it referred to its longer-run objectives but did not aggressively attempt to manage market expectations. In contrast, the Fed’s recent heavy reliance on forward guidance has kept bond yields low but has not contributed to stronger nominal GDP growth. It also has led to confusion and lack of policy clarity.
Economic growth would be stronger now if not for the convoluted tax system and the increasingly complicated web of costly regulations in finance, labor markets and industry. But the Fed cannot correct these problems. The Fed’s worries about raising rates are vastly overstated. Yes, modest increases in interest rates will elicit some adjustments. But history suggests that they will result in better economic and financial performance.
This piece originally appeared in The Wall Street Journal.
This piece originally appeared in The Wall Street Journal