Q: What is the likelihood that the Fed will raise rates in September? If it does raise rates, by how much will it do so?
A: After the July Federal Open Market Committee meeting statement, the odds of a 25 basis-point rate rise (0.25 percent) in September were slightly less than 50 percent. Those odds declined to 35 percent after last week's release of the FOMC July meeting minutes. The odds have fallen further in recent days as turmoil has engulfed global financial markets. The FOMC has said unambiguously that its decision will be data dependent. U.S. data since the July FOMC meeting has been mildly weaker than expected, but global data trends have been much worse. Financial markets no longer expect a rate increase in September. While markets could stabilize in the next couple of weeks and U.S. data could come in stronger than expected, there is now relatively low risk in the FOMC waiting until the October or December meetings to raise rates. As to the range of the increase, the FOMC has been very clear that whenever it increases rates for the first time, it will raise the target range from 0 to .25 percent to .25 percent to .50 percent.
Q: What are the risks of not raising rates? Or what are the risks of raising rates prematurely?
A: The risk of not raising rates right away is that the associated abundance of market liquidity continues to stoke speculation in assets — think of this as keeping the costs of leveraging though the use of debt very low. Or, in short, the longer rates remain low as the economy slowly firms, the greater the risk is that assets, both financial and real, will overshoot fair value and possibly become a bit too bubbly. Note that I do not think there is any significant risk of unleashing inflation any time soon if rates are not rising immediately — global deflationary forces are very strong.
All other major economies — Europe, Japan, and China — either are decreasing interest rates or have publicly stated policies not to raise rates for a very long time. If the U.S. raises rates, capital will flow to the U.S. This will strengthen the dollar and a stronger dollar will depress U.S. manufacturing and drive inflation lower. Inflation is about 1.3 percent, using the Fed's favorite measure, which is well below the Fed's 2.0 percent target. Lower inflation in the U.S. would not be welcome and much lower inflation combined with low economic growth could proved dangerous for companies heavily dependent upon debt financing.
Q: What are the strongest statistical/economic indicators that it is time to end the nine-year period of ultra-low rates? Or: what data counsels holding off on a policy shift?
A: There is a body of economic thought, which is a minority rather than a mainstream view, that low interest rates have discouraged investment in productive activities and diverted abundant liquidity into price speculation in existing assets. The consequence, it is argued, is that the diminished investment in productive activities depresses productivity, which, in turn, depresses the potential rate at which the economy can grow. According to this view, consumer inflation-adjusted purchasing power improves more slowly while the speculation in asset prices benefits the wealthy. The combined impact is to gradually worsen income inequality between rich and poor progressively over time. To the extent there is validity in this view, it argues for higher rates sooner or later. But this must be juxtaposed with the potential destabilizing impact of a rate rise at a time when global financial markets are extremely fragile (see risk of raising rates above).
The contrary and more mainstream view is that raising rates too soon would depress inflation and economic growth. Inflation is well below the Fed's target and further downward pressure seems likely.
Obviously, there is no easy answer because, either way, the risks are considerable. Personally, I count myself as a proponent of the first view. In other words, rates need to be raised to eliminate imbalances that have accumulated during the lengthy period of virtually free money. However, it is unclear this can be done without creating significant market adjustments that could exacerbate recent market volatility and increase the risks of negative feedbacks into economic activity.
Q: How should we expect businesses and consumers to react to a rate rise? Would some sectors be helped more than others?
A: 25 basis-point increase in short-term rates is unlikely to have a significant impact. Longer-term rates, such as those on home mortgages, likely will not change. The yield curve will get flatter and it will become harder to arbitrage the yield curve to make trading profits. There remains, however, the matter of whether a small increase will change business and consumer behavior in ways that have negative consequences for economic activity. That is to say, changes in interest rates can impact markets and economic activity in two ways. First, by increasing the cost of borrowing, a rate rise will it more costing to buy cars. However a 25 basis-point increase is pretty immaterial. Further rate increases, however, would bite progressively. The greater short-run potential consequence would occur if businesses and consumers interpret a small rate increase as signaling much more to come and change their current behavior in anticipation. For consumers, that could lead to spending less, saving more and borrowing less. For businesses it would mean postponing expansion initiatives in the expectation of slower growth in demand (slower revenue growth). Business and consumer sentiment could well interact to reinforce a significant decline in confidence and a self-fulfilling decline in economic activity.