Barring a disastrous November employment report or upheaval in financial markets, the era of the Federal Reserve's zero interest rate policy is set to come to an end later this month. Deep dive: The end of ZIRP
The important question to ask is whether it should. While some economists seem divided, financial markets have increased bets that the Fed will follow through and raise the fed funds rate in December. In theory, economic fundamentals support an increase. Yet, the broader global economic context and asymmetric risks of acting prematurely has some, including a few Fed officials, attempting to build a case for policymakers to wait longer before making a move. Deep dive: Measuring the arguments over why the Fed should wait
Arguments against an interest rate hike in December center on the slack in the job market, lack of inflation, and the risk of short-circuiting the expansion by acting too soon. We are less than a year from hitting full employment. Also, what matters for monetary policy is where inflation is headed. A tight rental market, higher healthcare prices, and less pass-through from low energy prices point toward higher core inflation next year.
Any time policy is at an inflection point, there will be disagreement and cold feet. There are some possible arguments for delaying, but some of those arguments hold more water than others.
Prudent risk management could argue for delaying until 2016. The Fed could opt to wait for more concrete signs that inflation is moving toward its 2% target. Waiting would allow for the Fed to be sure that the tighter job market and reduced slack elsewhere in the economy is sufficient to generate stronger growth in core inflation, particularly as some of the weights, including an appreciating dollar, will remain persistent drags. Also, the Fed will be tightening monetary policy as other central banks, including the European Central Bank, ease. That should boost the global economy but put upward pressure on the dollar. Deep dive: PCE Deflator
And the Fed may want to wait to make sure that current low inflation is really being caused by transitory factors, including low energy prices and the stronger U.S. dollar. Global factors have contributed to weakness in a key inflation indicator, the personal consumption expenditure deflator for U.S. goods prices. But growth in services has been unusually weak, rising less than the average since 1990. This suggests that other factors are depressing inflation.
The Fed may also prefer to wait for evidence that wage growth is accelerating, which would be a clear signal that full employment is near. Fed Chair Janet Yellen has said that the Fed will allow the job market to run hot to help inflation return to the target, implying that there is less urgency to tighten as the job market hits or surpasses full employment, a point that is difficult to identify in real time.
Another argument for waiting is that December isn't the best time because of year-end funding issues, as trading normally declines around the holidays. However, volatility has settled down recently, and the trading standard deviation in the effective fed funds rate on the last trading day of December has recently been below the average for 2001 to 2014. Further, there isn't a ton of evidence that broader financial market conditions tighten significantly more in December, according to the St. Louis Fed's financial stress index. Therefore, we don't believe this poses an enormous hurdle.
In a similar vein, the Fed has not begun a tightening cycle in December since 1990. Also, over that span only 6% of all rate hikes occurred in December. The Fed was more likely to cut rates in December than increase them. Again, this could be just a fluke tied to how the meeting schedule fell during tightening cycles. Also, the Fed began tapering its quantitative easing program in December, evidence that the central bank isn't overly concerned about removing monetary stimulus in the final month of a year.
While what the Fed should do and ultimate does can be two different things, the economy can handle a small increase in interest rates, particularly as future increases will be gradual, so as to continue nurturing the expansion.
Our interpretation of gradual is a 25-basis-point increase in the target range for the fed funds rate at alternating meetings in 2016. However, this could prove to be too formulaic as the economy will improve in fits and starts next year. Also, a gradual commitment and data dependency don't work well together. The latter gives the Fed more flexibility and is likely the approach it will stress after the first rate hike.
It's also important to note that a 25-basis-point increase in rates won't do significant damage. The benchmark for assessing the stance of monetary policy is the gap between the actual fed funds rate and the nominal equilibrium rate of interest: When the federal funds rate is below the nominal neutral rate, monetary policy is accommodative, and, when it is above the neutral rate, policy is contractionary. Also, there are long and variable lags between when the Fed adjusts interest rates and when adjustments affect the economy.
Whether the liftoff occurs in December or a few months later is ultimately less important than the pace of rate hikes over the next few years. Raising rates in December, followed by a gradual tightening, would allow the Fed to nurture the expansion and reduces the odds that the economy overheats, forcing the Fed to aggressively tighten. In other words, the Fed needs to avoid a boom and bust cycle.
Therefore, slow and steady will win the race.