What Harm Could a Small U.S. Interest Rate Hike Do in 2014?

February 21, 2014

This subject was broached today on Bloomberg Radio.  There are many people, some even among Federal Reserve officialdom, who’d like to see a down payment on interest rate normalization be made sooner, lest people start to believe that officials opposed will always find reasons to argue that rate tightening is too premature.  The 0-0.25% fed funds range was established in December 2008 when the U.S. and global economy were free-falling  into a possible depression.  Zero interest rates are required for emergencies.  Almost five years after the onset of positive growth in the United States, 2014 has little in common with December 2008.  With a fed funds rate of 0.25% or 0.50%, monetary policy would still be more accommodative now than in late 2008 because of the heavy infusion of base money that the Fed provided subsequently.

The question seems a reasonable one until one looks at the history when policy was tightened in a market still unprepared.  Look, for example, at 1994.  The federal funds rate had been at a cyclical low of 3.0% from September 1992 until a timid 25-basis point increase in February 1994 that was followed by similar hikes in March and May.  By early July, without any more tightenings from the FOMC, the 10-year Treasury yield had climbed 1-3/4 percentage points to 7.43%.  In the three quarters through mid-1994, U.S. GDP rose at a 5.0% annualized rate, presumably more that ample for the economy to tolerate normalization, and inflation of 2.8% in July of 1994 was above the current inflation target of 2.0%, even the 2.5% envelope that Fed officials have said they could accept temporarily.  The experiment of 1994 slowed the U.S. economy more than officials had anticipated, all the way to a 1.4% pace in the first half of 2005. 

Just to throw out another example, an FOMC led by Alan Greenspan authorized a 50-basis point tightening of policy on September 3, 1987, less than a month into the new Chairman first term.  With America’s bout of double-digit inflation still very fresh in memory, the temptation was great for the Maestro to prove his anti-inflationary commitment.  That tightening was a key factor in the chain of events that produced a single-day 22.6% plunge in the DJIA on October 19. 

In 1987 or even 1994, it seemed inconceivable that too little inflation could be a bigger problem than too much.  Tightening monetary policy when inflation is already too low could produce an exaggerated market response and jeopardize the U.S. and global economic expansions.  It may turn out that well into 2015 or 2016 is later than when the Fed should implement its first rate hike, but there’s plenty of time to shorten the wait and move sooner.  One thing is for sure. A rate hike now or within a couple of months would surprise the market, and it’s easy to imagine how even a small symbolic move could produce considerable harm in the present environment.

Copyright 2014, Larry Greenberg.  All rights reserved.  No secondary distribution without express permission. 

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