The Federal Reserve announced Wednesday that it would raise benchmark interest rates for the first time since 2006, sending a wave of relief through financial markets and capping an era of historically unprecedented monetary policy.
In a move widely anticipated by investors, the U.S. central bank's Federal Open Markets Committee pushed the federal funds rate up a quarter of a point from the near-zero levels that have prevailed for seven years. The new benchmark rate, which is what commercial banks pay to borrow from the Fed, will float between 0.25 percent and 0.5 percent, raising the cost of everything from new mortgages to credit card debt.
“The tempest is over,” said Richard X. Bove, equity analyst with Rafferty Capital Markets.
The Fed's move means a measure of relief not only for finicky debt markets, but also for the Fed itself, which has faced unprecedented public scrutiny since the extraordinary measures it introduced seven years ago, to the day, to help hasten the economic recovery in the wake of the financial crisis.
“You get these situations where what the Fed says is all important to everybody,” Bove said an interview Tuesday. But now, he said, the Fed “wants to get out of the limelight.”
Charged with maximizing employment while keeping inflation in check, the Fed sets interest rates at a level that will aid the economy without leading to excess borrowing and out-of-control consumer prices.
A 'Dovish Hike'
With the first rate hike in years now in the books, investors are looking ahead to the path of subsequent rate increases. Most expect a tempered pace. Yellen signaled as much earlier this month, explaining that the underlying “neutral” interest rate — one that neither accelerates nor slows the economy — is “likely to rise only gradually over time.”
Kathy Bostjancic, head of U.S. macro investor services at Oxford Economics, predicts the Fed will raise rates twice in 2016, ending the year at 0.88 percent, slightly below the median Fed projection of 1.38 percent.
On Tuesday, Bostjancic said that the Fed has to walk a fine line in delivering economic expectations, finding a middle ground between expressing economic optimism while reassuring markets that steep hikes are not in store.
“They don’t want rate expectations in the market to spin further away from them,” said Bostjancic, noting that futures markets project interest rates to rise significantly slower than the Fed predicts.
Subsequent rate hikes aren’t the only unknowns. The Fed holds more than $3 trillion in excess assets on its books, the result of years of stimulative bond buying carried out to help reduce home-buying costs. In time, the Fed will have to unwind its balance sheet, which could cause further financial upset as markets attempt to absorb a massive influx of Treasury bonds and mortgage-backed securities.
“This is really the beginning,” said Bove.
A Highly Telegraphed Move
Investors weren’t likely to be caught flat-footed by Wednesday's rate announcement, which Fed officials have hinted at for months. Fed Chair Janet Yellen called a December liftoff a “live option” in congressional testimony earlier this month.
“Never in Fed history has there been a policy change that has been more telegraphed,” said Kim Schoenholtz, a professor of economics at the New York University.
That’s due in part to what the Fed calls forward guidance, an attempt to give markets adequate time to prepare for coming policy changes. This time around, the Fed’s messaging left investors “pretty well teed-up in terms of market expectations,” said Mark Heppenstall, CIO of Penn Mutual Asset Management.
That long windup has also given critics the chance to air their differences with the Fed. A growing number of high-profile economists, including Nouriel Roubini and former Treasury Secretary Larry Summers, have argued that inflation is too low and the labor market too weak to justify a rate hike.
Wage growth for working Americans has been particularly anemic, and as a recent Georgetown University study found, the economy remains 6 million jobs shy of where it would be absent the financial crisis.
Lawmakers have also raised concerns. Rep. John Conyers, D-Mich., wrote an op-ed Tuesday pressing the Fed to hold its fire. “Our jobs recovery is not complete,” Conyers wrote, suggesting the Fed’s actions could “pull the rug out from under the recovery, setting a troubling precedent by slowing the economy before it's ready.”
But others have argued for the Fed to raise the federal funds rate above its lower bound in order to have wiggle room in the event of a sudden recession. The federal funds rate is the interest major banks pay to borrow from the Fed. That rate is reflected in the cost of lending between depository institutions and, ultimately, the cost of retail borrowing.
End of an Era
In the grand scope of U.S. monetary policy -- which saw benchmark interest rates rise as high as 20 percent in the early 1980s -- Wednesday’s hike is relatively minor. But that doesn’t make Wednesday’s liftoff any less historic.
“The fact that they haven’t tightened in nine-plus years has really become the story,” said Heppenstall.
Though the effects of historically cheap credit are open to debate, some economists have cast Fed policy as an appropriate response to the recession. “The Fed had enormous impact during the crisis,” said Schoenholtz. Though the effects of monetary policy are tough to isolate, Schoenholtz said, the Fed was “critical in preventing a second Great Depression.”
As the U.S. central bank wrapped up its controversial emergency lending programs to distressed banks in 2010, it laid the groundwork for a unique period in U.S. monetary history. Combining rock-bottom interest rates with large-scale asset purchases, the Fed juiced the recession-stricken economy with a $3 trillion infusion of cash.
“It’s been a valuable undertaking, and it’s probably helped strengthen the economy,” Schoenholtz said. “But central bankers will be the first to say it’s not a panacea.”
Fed researchers have estimated that by making it cheaper for consumers to make big purchases and businesses to take out loans, ultra-low interest rates helped reduce unemployment rates by 1.2 percent.