People crossing a busy city street.

Insights on the Fed's Rate Hike

The Federal Reserve announced an initial interest rate hike of 25 basis points today. This special report, from one of our lead Economists, examines the implications of interest rate normalization—how will the economy react to rising rates? One of our lead economists weighs in.

By Jim Glassman, Head Economist, Commercial Banking

After months of anticipation, the Federal Reserve has finally begun what is likely to be a gradual process of normalizing interest rates. At today’s meeting, the Federal Open Market Committee announced an initial hike of 25 basis points, lifting interest rates from 0 - 0.25 to 0.25 - 0.50, the first move in seven years. Depending on the economy’s response, today’s action will likely be followed by another 25-point hike next spring. These will likely be the first two steps in a long series of incremental hikes that many expect will slowly return interest rates to their normal range over the coming years.

A Sign of Strength

Although the economy has not yet returned to its prerecession strength, the Fed’s decision to begin raising rates now is a sign of confidence in the outlook. Despite inflation running well below the official 2 percent target, employment continues to expand faster than the growth of the labor force, and the jobless rate has fallen to 5.0 percent, the lowest level since 2008.

Today’s decision will lift interest rates from zero for the first time since the 2008 financial crisis. In the years following the recession, even a zero percent rate was insufficient to spur growth, and the Fed launched an unprecedented program of large-scale asset purchases in an effort to push down longer-term interest rates and provide more economic stimulus. The Fed ended its asset purchase programs by the end of 2014, and now interest rates are heading back toward normal. Presumably, the Fed believes that the economy can thrive without extraordinary intervention, and interest rates will likely remain accommodative for years to come.

The decision to begin raising interest rates ahead of inflation should also provide the Fed with greater flexibility in the future. Future steps toward normalization will be made in anticipation of the economy’s trajectory—if growth begins to falter in the face of higher rates, the Fed will likely delay further hikes. Alternatively, if the labor market tightens and inflationary pressure begins to build in 2016, the Fed will be in a position to accelerate the pace of interest rate normalization without shocking the financial system.

The Immediate Impact

Today’s news could lead to elevated market volatility in the coming week, but it has been widely expected—as bearish positions are unwound, some temporary disruption can be expected, but the turmoil will likely pass quickly.

Ultimately, today’s rate hike should build confidence in the markets. For years, some investors have feared that equities prices were being propped up by artificially low interest rates. Now that interest rates have risen from zero, there should be no doubt that the stock market’s valuation is being driven by strong corporate earnings, rather than loose monetary policy. Although bonds will grow more attractive as interest rates continue to rise, it would be surprising if they lure investors away from equities—stocks will continue to enjoy much stronger growth potential than bonds for several years to come.

Where Is the New Normal?

Now that normalization has begun, attention is turning toward the end goal. In the past, policy makers have assumed that the ideal interest rate sits 2 percent above the core rate of inflation. Given the official inflation target of 2 percent, this would eventually place interest rates at 4 percent. Whether this is still true remains to be seen—new regulations are likely to produce some drag in the financial sector, and a lower margin may be sufficient to contain inflationary pressure. Uncertainty about the behavior of inflation further compounds the difficulty of making long-term predictions. The Federal Open Market Committee believes rates will eventually top out between 3 and 4 percent (the central tendency of policymakers’ forecasts for the ultimate level of the federal funds is 3.25 to 3.75 percent), but the final equilibrium will depend on developments in the labor market over the next two years.