Federal Reserve shows confidence in economy by raising interest rates

The Federal Reserve’s move to raise short-term interest rates Wednesday was a vote of confidence in the strength of the American economy at a time when much of the rest of the global economy is struggling.

The widely anticipated decision — raising short-term interest rates for the first time since the financial crisis struck — was a milestone in the Fed’s post-crisis stimulus campaign and ends a seven-year period in which the Fed held short-term rates near zero. Even as it raises its benchmark interest rate by 0.25 percentage points, to a range of 0.25 to 0.5 percent, however, the Fed emphasized subsequent increases would come slowly.

The decision to raise rates “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,” the Fed’s chairwoman, Janet L. Yellen, said at a news conference after the decision was announced.

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

Financial markets greeted the rate move with relief and stock prices rose steadily through the afternoon after the Fed decision.

“The market likes what she has to say,” said Michael Arone, the Boston-based chief investment strategist at State Street Global Advisors' U.S. Intermediary Business.

The Dow Jones industrial average gained 224.18 points, or 1.3 percent, to 17,749.09. The Nasdaq composite gained 75.77 points, or 1.5 percent, to 5,071.13.

The Standard & Poor’s 500 index added 29.66 points, or 1.5 percent, to 2,073.07, marking a 3 percent gain over the last three days.

Interest rates on U.S. Treasurys climbed, pushing prices down, but yields on the key 10-year note failed to rise above levels seen earlier this month.

Moving to raise rates is the most important and riskiest decision the Fed has made under the leadership of Yellen, the Fed’s chairwoman since early 2014. Every other developed nation that has raised rates since the end of the financial crisis has been forced to backtrack as economic conditions proved unable to handle higher rates. There are also signs of strain in some financial markets as investors dump high-yield junk bonds and pull money from developing markets.

This is “an inopportune” time for the Fed’s first rate boost, said Mark Eveans, chief investment officer of Meritage Portfolio Management in Overland Park.

Corporate sales and profits are peaking, he said, as the economy is well into its recovery, and those worries in the junk bond market bode ill.

Eveans said he would have expected a Fed rate increase three years ago when the economy started producing jobs at a reasonable clip. Others agreed that an earlier rate boost would have made sense.

The Fed had “an opportunity” to raise rates a year ago, and no one today would even remember that it had, said Scott Colbert, chief economist at Commerce Trust Co. in St. Louis. Had it though, Colbert said, the complaint would be that stocks hadn’t done much since the Fed move, commodity prices have fallen sharply and other issues have emerged.

Ken Green, president of Mitchell Capital Management Inc. in Leawood, called Wednesday’s rate increase long overdue.

“What gets lost here is how far away from normal (interest rates) we are,” Green said.

The decision to raise rates was supported by all 10 voting members of the Federal Open Market Committee. They agreed on the move despite concern expressed in recent months by three of those officials that the economy might not be ready for higher rates, a view shared by some outside economists and by Democrats who argue the Fed is prematurely curtailing job and wage growth.

The Fed’s announcement cited the strength of job growth, and the broader backdrop of a moderate-but-steady economic expansion, as evidence that the economy no longer needed quite as much help from ultra-low borrowing costs.

Fed officials predicted in a set of forecasts also published Wednesday that they would raise interest rates by about one percentage point a year over the next three years, reaching 3.3 percent by 2019.

The Fed said that beginning Thursday, it would seek to keep short-term interest rates in its new range. To set the new baseline, the Fed said it would pay banks an interest rate of 0.5 percent on unused money, and it 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.

Even as the Fed said it would raise rates, it released a set of updated economic projections from its senior officials underscoring that they expect the economy to grow slowly in coming years. The officials predicted, on average, that the economy would expand by 2.4 percent next year and that the unemployment rate would reach a new low of 4.7 percent.

But they expected somewhat slower growth in subsequent years. And even as joblessness remains low, they predicted that 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.

Yellen herself posed the question in her statement, “With inflation currently still low, why is the committee raising the federal funds rate target?”

She said that inflation was being suppressed temporarily by factors including lower oil prices and that it would rise as job growth continued. She added that the Fed needed to act now because monetary policy influences economic conditions gradually.

If the Fed waited to raise rates, Yellen said, “We would end up having to tighten policy relatively abruptly at some point.” She continued, “Such an abrupt tightening could increase the risk of pushing the economy into recession.”

Looking ahead, the rate at which the Fed tightens its monetary reins will be the central question confronting Yellen and her colleagues as the 6 1/2 -year-old economic expansion unfolds in unpredictable ways. The challenges will be heightened even more by the fact that 2016 is a presidential election year.

The unemployment rate has fallen to 5 percent, a level historically consistent with a healthy economy — and is the primary reason the Fed has decided to act. Inflation, however, remains quite weak, indicating that the economy remains weak too.

The Fed must also gauge the impact of global weakness on the U.S. economy; the strong dollar appears to be weighing on manufacturing in particular.

Critics of the Fed’s decision argue that the unemployment data are misleading. The share of adults neither working nor looking for work rose sharply during the recession. Those adults are not counted in the unemployment rate, but some may resume looking for work as the economy improves.

“Our job recovery remains incomplete,” Rep. John Conyers, a Michigan Democrat, wrote earlier this week. He has introduced legislation instructing the Fed to aim for an unemployment rate of 4 percent, well below the current rate. “The Fed should not slow job creation and wage growth absent clear evidence of inflation,” he said.

Some analysts said they expected problems in the auto market, where cheap loans have spurred booming sales. While housing sales remain well below pre-recession levels, car sales have climbed to record heights in recent years. “It will hurt borrowers and it will hurt the real economy because that’s what’s driving the auto industry right now,” said William Spriggs, the chief economist at the AFL-CIO.

Still, while rates on mortgages and other kinds of loans tend to rise with the Fed’s benchmark rate, the relationship is not mechanical. During the housing boom, mortgage rates declined even as the Fed raised short-term rates because of increased foreign investment. That pattern could recur if investors once again conclude the United States is a better investment than other parts of the world.

The era of minimal returns on savings also won’t end soon. Berkley Bank in Englewood, Colo., currently offers an interest rate of 0.50 percent on a one-year certificate of deposit. Brandon Berkley, the bank’s president, said the Fed’s rate increases eventually would translate into higher rates for his depositors and borrowers, but he said the bank might not start raising rates immediately.

In raising rates, the Fed is entering an unfamiliar world. Only two members of the Fed’s policymaking committee participated the last time the Fed raised rates, between 2004 and 2006: Jeffrey Lacker, the president of the Federal Reserve Bank of Richmond since 2004, and Yellen, who was then the president of the Federal Reserve Bank of San Francisco.

The Fed also plans to raise interest rates in a new way. Usually, the Fed 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 plans to pay banks and other financial firms not to lend below its new benchmark rate.

Short-term rates climbed in anticipation of the Fed’s announcement in recent weeks, suggesting that investors expect the new system to work. But Alan Blinder, an economist at Princeton University and a former Fed official, cautioned that the Fed’s best-laid plans have rarely unfolded smoothly.

“I never worry about markets underreacting,” he said dryly.

This story was originally published December 16, 2015 at 6:48 PM with the headline "Federal Reserve shows confidence in economy by raising interest rates."