Last Week’s Decision to Raise Interest Rates

On December 16th, as widely expected, the Federal Open Market Committee decided to raise the target range for the federal funds rate by 1/4 percentage point, raising it from 1/4 to 1/2 percent. This was the first rate increase in more than a decade.

As Federal Reserve Chairman Janet Yellen remarked, “This action marks the end of an extraordinary seven-year period during which the federal funds rate was held near zero to support the recovery of the economy from the worst financial crisis and recession since the Great BWM_Blog Janet Yellen.2015.12.21Depression.”

Chairman Yellen also noted that the move recognizes the “considerable progress that has been made toward restoring jobs, raising incomes, and easing the economic hardship of millions of Americans. And it reflects the Committee’s confidence that the economy will continue to strengthen. The economic recovery has clearly come a long way, although it is not yet complete. Room for further improvement in the labor market remains, and inflation continues to run below our longer-run objective.”

Deeming the first increase in interest rates in nearly a decade “appropriate,” Chairman Yellen detailed a host of improvements in the economy that support the Fed’s move. She stated, “So far this year, a total of 2.3 million jobs have been added to the economy, and over the most recent three months, job gains have averaged an estimated 218,000 per month, similar to the average pace since the beginning of the year. The unemployment rate, at 5 percent in November, is down six tenths of a percentage point from the end of last year and is close to the median of FOMC participants’ estimates of its longer-run normal level. A broader measure of unemployment that includes individuals who want and are available to work but have not actively searched recently and people who are working part time but would rather work full time also has shown solid improvement.” She then pointed out that “Cyclical weakness likely remains: The labor force participation rate is still below estimates of its demographic trend, involuntary part-time employment remains somewhat elevated, and wage growth has yet to show a sustained pickup.

Concluding that the risks to the outlook for both economic activity and the labor market appear “balanced,” Chairman Yellen said, “The Committee currently expects that, with gradual adjustments in the stance of monetary policy, economic activity will continue to expand at a moderate pace and labor market indicators will continue to strengthen. Although developments abroad still pose risks to U.S. economic growth, these risks appear to have lessened since late summer.

Most experts look for a number of rate increases in 2016, ranging from two to four.

To understand the complexity of how Fed decisions wash out though the economy, take a look at this innovative display: What Happens When the Fed Raises Rates In One Rube Goldberg Machine. After illustrating a variety of complex interactions and results for the economy, the conclusion is, “There is a strong possibility that the Fed’s decision on Wednesday to raise rates will not cause much of anything to happen. And if indeed this is the case, the Fed will have actually succeeded in running its machine.” That is, Chairman Yellen took such great pains to telegraph the rate increase that the market was not surprised about the FOMC decision. In fact, the market had the opportunity to prepare in advance. We’ll see if this approach continues in 2016.

In the meantime, if you have questions about this and future interest rate adjustments and your portfolio, you are invited to give us a call to discuss.

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