Does the Fed Need to Hike Interest Rates?

In her speech last Thursday, Federal Reserve Chair Janet Yellen reiterated her plan to increase interest rates this year despite doubts about the Fed’s ability to generate its 2% inflation rate target.

Matt Phillips in Quartz: “In explaining the Fed’s decision earlier this month to hold off on raising interest rates, Yellen highlighted persistently low market measures of inflation expectations. That’s a sign that the markets doubt the central bank’s ability to actually generate enough inflation to get back to its 2% target. And for good reason, the Fed has consistently been undershooting its inflation target in the aftermath of the Great Recession.”

Matthew Yglesias argues against a rate increase.

“Economic commentators seem to have a great deal of difficulty with this, but it’s time to admit that at the moment the United States simply isn’t facing a serious business cycle problem. Unemployment is on the low side, but so is inflation. Cheap commodity prices are giving everyone a boost, there are a lot of able-bodied adults who may or may not rejoin the workforce in the near future, and after a long stretch of weak wage growth there’s room for people to get some raises without corporate profits being squeezed to an untenable level.”

“Things are basically fine, and while a small increase in interest rates almost certainly wouldn’t be ruinous, there’s also no reason to do it.”

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  • shrpblnd

    A target rate of 2% inflation is contrary to the law. The Federal Reserve Act specifically states the Fed shall maintain “stable prices.” Stable means unchanging and so the target rate of inflation should be 0. A 2% inflation rate over a 30 year period robs consumers of half of their purchasing power.

    • lobwedge

      Quoted below is the exact text of “Section 2A. Monetary policy objectives” of the current text of the Federal Reserve Act:

      “The Board of Governors of the Federal Reserve System and the Federal Open Market Committee shall maintain long run growth of the monetary and credit aggregates commensurate with the economy’s long run potential to increase production, so as to promote effectively the goals of maximum employment, stable prices, and moderate long-term interest rates.”

      A target inflation rate is in no way “contrary to law”. Inflation is a very complex economic principle with both positive and negative affects.

      Economists don’t all agree on the ideal level of inflation but deflation is almost universally recognized as being a problem.

      The FOMC believes that over the medium and long term a 2% rate of inflation is most consistent with it’s mandates of “maximum employment” and “stable prices.” They are currently using a lower short term target as a tool to prevent recession.

      • shrpblnd

        A target rate of inflation above 0% is contrary to the law, as that is not stable prices. The concept of a 2% target is indeed a completely recent target, that the Fed just made up. First, there is no evidence at all that this level of inflation will maximize employment or prevent deflation. Far more damaging to the economy is the serial asset bubbles being blow by the Fed in an attempt to prevent deflation. In fact, deflation that matches the productivity growth of the economy is the natural state, and is not harmful.

        The perfect example of this is the computer industry which has experienced deflation for several decades as both computer hardware and software have got progressively cheaper, but this is a net benefit to both businesses and and consumers.

        In the mid 80’s a PC might cost $4,000 – 5,000, and now they are routinely under $1,000 and far more powerful. Most consumers now carry a smart phone in their pocket that is far more powerful then the computers used to send men to the moon. Yet this has hardly devastated the computer industry. In fact this has only encouraged the field to grow more.

        • lobwedge

          We probably disagree on what “stable prices” means but even so the law quoted above does not state that prices must remain stable. It states that the FOMC…

          “shall maintain long run growth of the monetary and credit aggregates
          commensurate with the economy’s long run potential to increase
          production” …

          and then adds it shall do that …

          “so as to promote effectively the GOALS [plural] of maximum employment, stable prices, and moderate long-term interest rates.”

          There are three “goals” there. One does not take precedence over the others and they all can’t be fully controlled so the Fed uses a variety of tools and techniques to “promote” all three goals as best as possible. One of those tools is a target inflation rate. The Fed is not omnipotent and can’t set the inflation rate. A negative inflation rate (deflation) is always bad for growth therefore if the target is set at zero there is no room for error in preventing deflation and if the target is missed on the low side deflation will occur hence they must set a target somewhere above zero to “maintain long run growth of the monetary and credit aggregates.”

          At one point you state “deflation that matches the productivity growth of the economy is the natural state and is not harmful”. Deflation can be a natural state but the Fed’s mandate is not to promote a “natural state” it’s to “maintain long run growth of the monetary and credit aggregates commensurate with the economy’s long run potential to increase production” and deflation is always harmful to growth.

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