For this week’s #FeatureFriday, we analyze the impacts of the recent rate hike by the Federal Reserve, and its implications on different aspects of the U.S. economy.
The Fed, or the Federal Reserve System, is the central banking system of the United States. The main act within the Fed, known has the Federal Reserve Act, hopes to achieve its three key objectives: maximizing employment, stabilizing prices (ie maintaining a low and stable inflation rate), as well as moderating long-term interest rates through the use of monetary policy.
On Wednesday, 14th Dec 2016, to wide anticipation, the chairman of the U.S. Federal Reserve, Janet Yellen, announced that the Fed would raise its interest rates by a quarter percentage point to between 0.5% and 0.75%. This has only been the second raise since the central bank cut borrowing costs to near-zero in 2008. However, the real surprise to many is the foreshadowing that the Fed will most likely raise interest rates three more times in 2017, one more than many have predicted earlier.
THE TRADE OFF – ECONOMIC GROWTH AND INFLATION
A monetary policy is defined as the actions taken by the central bank of a country. Therefore, for a central bank like the Fed’s monetary policy are actions such as buying or selling government bonds, changing the money supply, and like the Fed had done on Wednesday, modifying the interest rate.
The Fed, like most central banks, faces a trade off between economic growth and the inflation rate within the economy. By cutting interest rates or keeping them low, the cost of borrowing decreases, leading to an expansion in the economy through higher planned investment. However, this also leads to higher inflation rates due to a higher aggregate demand in the economy, causing what is known as demand pull inflation.
Vice versa, an alternate effect is achieved when the inverse happens, as it did with the Fed, by announcing higher interest rates, thus lowering inflation levels, but at the same time slowing economic growth.
As discussed, one of the main objectives of the Fed is to maintain a sustainable inflation rate. However, despite the fact that inflation levels were at 1.7% in 2016, below the 2% target set out by the central bank, the Fed still announced a rate hike leading to many economists’ reactions as well as speculation as to the motive behind this move.
RELATIONSHIP BETWEEN YELLEN AND TRUMP
The historic power struggle between the Federal Reserve and the President had been well dated. Unfortunately, politics, more often than not, comes into play. When two objects collide, it inevitably leads to damage of a collateral nature. The rate hike by the Fed chair Janet Yellen, had many speculate that it had to do with incoming president Donald Trump and his ideology of expansionary fiscal policies to stimulate the economy.
“I would say at this point that fiscal policy is not obviously needed to provide stimulus to help us get back to full employment,” Yellen said.
She then continued by saying, “Nevertheless, let me be careful that I am not trying to provide advice to the new administration and Congress on what is the appropriate stance of policy. There are many considerations that Congress needs to take account of.”
When Trump was elected, he had pledged to cut taxes and increase government spending, specifically to invest $1 trillion on infrastructure, the very policy that Yellen had made a public stance of it not being needed for economic growth.
Another concern by Yellen regarding the fiscal policies is that the government’s debt could become a heavier burden.
“As our population ages, the debt-to-GDP ratio is projected to rise,” she said. “And that needs to continue to be taken into account.”
Trump was publicly critical of Yellen and her policies during his election campaign, with many speculating that she would be replaced when her term ends in 2018. This move by Yellen has undoubtedly created even more attention on the relationship between the two.
The plans for future rate hikes had also provided clues as to where Yellen positions herself. By having future rate hikes and plans, it indicated that she seeks to serve out her full term as Fed Chair. However, further consideration about whether she’d stay on the Fed Board as a governor in case she isn’t given another term as chair is a “decision for another day.”
Much of this discussion effectively boils down to how Trump enacts his policies when he takes office, whether he enforces expansionary fiscal policies, effectively creating more jobs, might just be the very center of Yellen’s worries. Yellen, being a true supporter in the Phillips curve, which is defined as the inverse relationship between unemployment rate and inflation levels. She does have much reason to worry about the President-elect’s motives. The current unemployment rate is at a nine year low at 4.6%, lower than the targeted unemployment rate at 4.8%, thus causing fear that his policies come at an expense of high levels of inflation.
However, there are some who view the two’s interests to be in alignment in their policies, despite the political differences. For Trump, his methodology of wanting low unemployment and faster economic growth, and as for Yellen, her policies have a primary aim at keeping inflation low. Trump will walk into office with an interesting economic environment – traditionally, tensions arose between presidents and Fed chairmen when the former wanted low unemployment, while the latter wanted low inflation. The interesting nature of the current economic climate, where the inflation is below Fed’s 2% target, whilst the unemployment rate is at 4.6%, also lower than the targeted unemployment rate by the Fed. Therefore, it would seem, as of now, their policies seem to be on the same page.
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