Finally free: Federal Reserve raises key rate amid improving growth forecasts

The Federal Reserve has finally been set free. After years of being shackled to low interest rates, the Fed embarked today on a journey to higher rates.

It raised its target for short-term interest rates for the first time in a year and the second time since the end of the Great Recession. It did so on the back of a strengthening U.S. economy.

This interest rate hike was only a quarter of a percent, but it is likely the first of many, as the economy’s health finally catches up with the Fed’s simmering desire to raise rates. The Fed’s desire to normalize monetary policy, however, has often run ahead of the economic recovery.

Starting in mid-2014, Fed officials began talking up future interest rate hikes. This talk continued into 2015 and translated into investors expecting higher U.S. interest rates.

{mosads}That expectation, in turn, pulled in funds from abroad and caused the dollar to strengthen by over 20 percent by the end of 2015, a historically sharp appreciation. 

The higher expected interest rates and the stronger dollar effectively tightened U.S. monetary policy. This tightening weakened the already tepid U.S. recovery in 2015, as seen in the slowing growth of GDP that year.

It also put a stranglehold on the global economy. Many countries have their currencies pegged to the dollar and others have large dollar-denominated debts.

The sudden 20 percent-plus surge in the dollar’s value worked through both channels to crush many emerging markets and exacerbate the global stock market sell-off in late 2015.

As widely expected, the @FederalReserve hiked by 25 bps. More interestingly, #Fed officials are now signaling more hikes-3 in total-for 2017

— Mohamed A. El-Erian (@elerianm) December 14, 2016

The Fed had, in short, gotten ahead of the recovery in 2015 by aggressively talking up interest rate hikes. The actual interest rate hike at the end of 2015 was simply icing on the tightening cake. 

This past year largely followed the same script. The Fed would talk up interest rate hikes and cause economic conditions to worsen.

It would then dial down its hike talk and give breathing room to the economy. As soon as there was a glimmer of good economic news, the Fed would return to rate hike talk. 

The Fed initially called for four interest rate hikes in 2016. Early this year, however, the Fed became concerned about financial stress and the global economy. It proceeded to tone down talks of a rate liftoff.

By the time the Federal Open Market Committee (FOMC) met in March, some Fed officials were even concerned about raising interest rates in April. Over the next few months, though, incoming economic data was improving, so Fed officials once again began dialing up their tightening talk.

A rate hike at the June FOMC meeting seemed possible. The rhetoric quickly changed following an awful May jobs report (only 24,000 added jobs) came out in June.

This rate hike back-and-forth continued through most of this year with the Fed making no actual decision on interest rates. It was once again getting ahead of the weak recovery. 

Everything changed with the election of Donald Trump in November. The president-elect’s win put into play a dramatic shift in expectations for economic growth via his plans for infrastructure spending, tax cuts, and various supply-side reforms.

Since Trump’s victory, the stock market is up almost 9 percent and the 10-year Treasury interest rate has jumped from 1.8 to 2.5 percent. Both signal higher spending and economic growth to come and are supported by recent gains in consumer confidence, wage growth, and consumer spending. 

As expected #FOMC raises rates by 25bps noting solid #employment, firming #inflation & expectations; and balanced #risks to the outlook #Fed pic.twitter.com/froKijOaAx

— Gregory Daco (@GregDaco) December 14, 2016

It seems the U.S. economy is finally poised for robust economic growth, something that has been missing for the past eight years. Such strong economic growth is expected to cause the demand for credit to increase and the supply of savings to decline.

Together, these forces are naturally pushing interest rates higher. The Fed’s interest rate hike today is simply piggybacking on this new reality. 

One of the big lessons from this rate decision is that the Fed cannot sustainably push up interest rates through the brute force of monetary policy. Rather, interest rates have to be pulled up by robust economic growth with the Fed following suit. 

This understanding also means the Fed did not push interest rates to zero percent in late 2008. Rather, it followed the collapsing market forces that were pulling interest rates down at the time.

To the extent the Fed wants a stable economy, it is limited in how much it can adjust interest rates. Its interest rate adjustments have to follow the health of the economy. 

Luckily for the Fed, the health of the U.S. economy seems to have turned the corner and begun a robust recovery. This has allowed the Fed to finally break free from the chains of low interest rates.

David Beckworth is a senior research fellow with the Program on Monetary Policy at the Mercatus Center at George Mason University and a former international economist at the U.S. Department of the Treasury.

The views expressed by contributors are their own and not the views of The Hill.