Fed Raises Key Interest Rate for First Time in Almost a Decade

By BINYAMIN APPELBAUMDEC. 16, 2015

News Clips: U.S. By REUTERS 1:27

Fed Announces Interest Rate IncreaseContinue reading the main story Video

Fed Announces Interest Rate Increase

Janet L. Yellen, chairwoman of the Federal Reserve, explained the decision to raise the benchmark interest rate by 0.25 percentage points.

By REUTERS on Publish Date December 16, 2015. Photo by Jonathan Ernst/Reuters. 

WASHINGTON — The Federal Reserve said on Wednesday that it would raise short-term interest rates for the first time since the financial crisis, a decision it described as a vote of confidence in the American economy even as much of the rest of the world struggles.

The widely anticipated announcement — that the Fed would raise rates to a range between 0.25 percent and 0.5 percent — signals the beginning of the end for the central bank’s stimulus program. Fed officials emphasized that they intended to raise rates gradually, and only if economic growth continues. Short-term rates will rise by about one percentage point a year for the next three years, Fed officials predicted.

Interest rates on mortgages and other kinds of loans, and on savings accounts and other kinds of investments, are likely to remain low for years to come.

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“The economic recovery has clearly come a long way, although it is not complete,” the Fed’s chairwoman, Janet L. Yellen, said at a news conference after the announcement.

Continue reading the main story

What Happens When the Fed Raises Rates, in One Rube Goldberg Machine

Exactly seven years ago, the Federal Reserve cut interest rates to almost zero in order to nurse the ailing economy back to health. Today, it is expected to change direction. This is how it works.

The decision “recognizes the considerable progress that has been made toward restoring jobs, raising incomes and easing the economic hardships that have been endured by millions of ordinary Americans,” Ms. Yellen said. The Fed’s announcement came exactly seven years to the day after the central bank cut its benchmark rate nearly to zero.

The Fed is trying to tiptoe between two kinds of danger. It wants to raise rates to improve its defenses against future risks, including higher inflation or another economic downturn. But if it moves too quickly, it risks undermining the current recovery.

It faces the additional challenge of increasing domestic rates while other central banks are holding rates down.

The result, said Mohamed El-Erian, chief economic adviser at Allianz, is a plan for the “loosest tightening” in the Fed’s modern history.

Move too quickly, Mr. El-Erian said, and the Fed could “cause severe market volatility, undermining economic conditions.”

Officials said the economy was strong enough to keep growing with a little less help from the central bank. They said rates would rise slowly, but borrowing costs already have started to climb.

OPEN Graphic

The decision on Wednesday was the most important and riskiest step the Fed has taken since Ms. Yellen became chairwoman in early 2014. Every other developed nation that has raised rates since the end of the financial crisis has been forced to backtrack as growth slowed.

Financial markets took the news calmly. The Standard & Poor’s 500-stock index rose 1. 5 percent to close at 2,073.07. The yield on two-year Treasuries, closely tied to short-term interest rates, closed above 1 percent for the first time since April 2010.

Ms. Yellen will now face the challenge of maintaining an internal consensus over the pace of rate increases amid considerable economic uncertainty and the political pressures of a presidential election year.

Ms. Yellen won the support of all 10 voting members of the Federal Open Market Committee, a victory that reflects the Fed’s tradition of maintaining the appearance of consensus on major decisions.

Three of those officials had argued in recent months that the economy might not be ready for higher rates, a view shared by some economists and by Democrats who argue that the Fed is prematurely curtailing job and wage growth.

The Fed’s Statement

“The committee currently expects that, with gradual adjustments in the stance of monetary policy, economic activity will continue to expand at a moderate pace and labor market indicators will continue to strengthen.”

From the Federal Open Market Committee statement released on Wednesday.

“When millions of Americans are working longer hours for lower wages, the Federal Reserve’s decision to raise interest rates is bad news for working families,” Senator Bernie Sanders of Vermont, a Democratic presidential candidate, said in a statement on Wednesday. “The Fed should act with the same sense of urgency to rebuild the disappearing middle class as it did to bail out Wall Street banks seven years ago.”

Some Republicans, meanwhile, bid good riddance to the era of near-zero interest rates.

“Unsustainably low interest rates clearly didn’t solve the problem, or else Americans today wouldn’t be stuck in the slowest, worst-performing economic recovery of our lifetimes,” Representative Jeb Hensarling, Republican of Texas Republican and chairman of the House Financial Services Committee, said in a statement.

The Fed cited strong job growth, and the broader backdrop of a moderate but steady economic expansion, as evidence that the economy no longer needed quite as much of its help.

“The committee judges that there has been considerable improvement in labor market conditions this year, and it is reasonably confident that inflation will rise over the medium term to its 2 percent objective,” the Federal Open Market Committee said in a statement on Wednesday after a two-day meeting.

Photo

Protesters gathered outside the Federal Reserve Bank of New York on Tuesday. Critics of a rate increase argue that unemployment data, an indicator that the central bank has monitored, is misleading. Credit Stephanie Keith/Reuters

The Fed also released economic projections by its senior officials underscoring that they expect slow growth. The officials predicted, on average, that the economy would expand by 2.4 percent next year, while the unemployment rate would drop to 4.7 percent. Even as they forecast joblessness would remain low, they predicted inflation would rise only gradually to the 2 percent annual pace the Fed regards as most healthy.

Most officials predicted the Fed would once again miss its 2 percent inflation target next year.

At the news conference, Ms. Yellen faced repeated questions about the persistent sluggishness of inflation. She posed the question to herself in her opening statement, “With inflation currently still low, why is the committee raising the federal funds rate target?” Because, she said, inflation was being suppressed temporarily by factors like lower oil prices but would rise as job growth continued. She added that the Fed needed to act because monetary policy works gradually.

“Abrupt tightening could increase the risk of pushing the economy into recession,” Ms. Yellen said.

The Fed’s initial rate increase, effective on Thursday, is likely to have a modest impact on the broader economy. JPMorgan Chase, the nation’s largest bank, announced soon after the Fed’s decision that it would raise its prime rate to 3.5 percent, increasing the interest rate on many loans. But the bank said it would not increase the rate it pays on deposits.

Wells Fargo and Bank of America similarly took advantage of the Fed’s decision to fatten profit margins rather than pass along the benefits to savers.

As the Fed’s benchmark rate rises, mortgage rates and other long-term borrowing costs are likely to rise too, but the relationship is not mechanical. During the housing boom, mortgage rates barely budged as the Fed increased short-term rates because of increased foreign investment. That pattern could recur if investors once again conclude that the United States is the safest place to park money.

Still, some analysts said they expected higher rates would begin to curtail economic activity fairly quickly, pointing for example to the auto market. Cheap loans have spurred car sales to record heights even as home sales have lagged. Higher rates “will hurt borrowers and it will hurt the real economy because that’s what’s driving the auto industry right now,” said William Spriggs, chief economist at the A.F.L.-C.I.O.

Financial markets began the process of adjustment in anticipation of the Fed’s announcement, and there, too, some signs of stress were evident. Corporations with questionable credit, for example, are paying more to borrow money. Average yields on junk bonds climbed to 8.86 percent on Tuesday from 6.72 percent in January.

There is considerable uncertainty about the consequences, however. The Fed plans to raise rates in a new way. Usually, it drives up borrowing costs by draining money from the financial system.

But it has pumped so much money into the system as part of its stimulus campaign that drainage is impractical. Instead, beginning Thursday morning, the Fed planned to pay banks and other financial firms not to lend below its new benchmark rate.

To set the new base line, the Fed said it would pay banks a rate of 0.5 percent on unused money, and would borrow up to $2 trillion from other financial firms at a rate of 0.25 percent.

Those measures were stronger than markets had expected, reflecting the Fed’s determination.