Fed December update: Rate change finally - was it worth all the suspense?
December 17, 2015
It finally happened. The Federal Reserve announced Dec. 16 that it was raising short-term interest rates. This comes after the Fed had maintained rates near zero for seven years, and hadn't raised its rate policy range since mid-2006. Still, for all the waiting and suspense, is it possible this announcement will prove to be something of an anti-climax?
Winning the expectations game
The truth is, the Fed would be delighted if this rate increase did turn out to be an anti-climax. The Fed wants to gently guide the economy. The last thing it wants to do is shock the economy or the financial markets. The Fed talked about this rate increase for well over a year now. Financial commentators were almost unanimously predicting the Fed would raise rates at this meeting. Indeed, it was not so much a prediction as an assumption.
The reason the Fed likes to signal its intentions in advance of acting is that it allows the economic and market reactions to changes in rate policy to be spread out over a period of months. Greater transparency became a Fed priority under then-chairman Ben Bernanke, in sharp contrast to the "man-behind-the-curtain" image that his predecessor, Alan Greenspan, liked to project. As the current head of the Fed, Janet Yellen has followed Bernanke's transparency approach, and if the economy and markets take this rate increase in stride, she will have won this round of the expectations game.
Simply doing what everyone expected may be anti-climactic, but again, that is preferable to shocking the markets and the economy.
Long-standing policy of incrementalism
Another reason why this rate change may prove to be somewhat anti-climactic is that over the past two decades, the Fed has usually taken an incremental approach to rate changes. The announcement of a 0.25 percentage point increase in the Fed funds rate fits this little-at-a-time approach.
That policy of incrementalism goes back to Greenspan's Fed. The Fed has not changed rates by more than half a percent at once since 2008, and has not raised them by that amount since late 1994. If all goes well, the Fed can follow on with subsequent incremental rate increases, but this approach allows it to wait and see before committing to dramatically higher rates.
This approach is in contrast with the Fed's actions in the late 1970s and early 1980s, when it was battling rampant inflation. The year 1980 alone saw three monthly rate increases of greater than 3 percent.
What could key faster increases?
That inflationary period of the late 1970s and early 1980s is a reminder the Fed does not always have the luxury of an incremental approach. Inflation has continued to run below the Fed's 2 percent target, but should it jump sharply higher - perhaps because of a rebound in oil prices - the Fed would have to take more dramatic action.
So if you are worried about sharply higher rates, keep an eye on inflation. You can bet Janet Yellen and her colleagues will be.
Comment: How do you feel about the timing of the Fed hike? How do you think your finances will be affected in 2016?
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