July 22, 2016

Should the Fed Raise Interest Rates?

The eternal question "Is the Fed going to raise interest rates?" was asked again in the Wall Street Journal on Wednesday. In a piece stretching across most of page A2 the Journal predicts one or two interest rate increases over the next six months:
Many [Federal Reserve] officials have said they can be patient before raising rates again, meaning a July move is highly unlikely. But new rounds of strong economic data - particularly on hiring or on an uptick in inflation - could increase their sense of urgency in the months after their next meeting. Atlanta Fed President Dennis Lockhart, a centrist at the central bank whose views often represent a middle ground among officials, told reporters last week it remains likely that the Fed will raise interest rates this year, adding "I wouldn't rule out as many as two" increases.
An interest rate hike has been in the making for quite a while now, almost since Janet Yellen succeeded Bernanke in 2014. It is needed, but not for the reasons alluded to by the Wall Street Journal. 

There are several reasons to be skeptical of the "strong economic data" argument.

To begin with, the Journal itself reports that the job growth in the U.S. economy is tapering off, pointing to a 25-percent drop in monthly job creation numbers from the last quarter of 2015 to the second quarter of 2016. In theory this could mean that the U.S. economy is at full employment; when put in context, though, it adds to the likelihood of a downturn in the second half of this year. 

Next up is GDP growth itself, a variable the Journal does not comment on. In Q1 of 2016 inflation-adjusted GDP growth was 2.09 percent. The four-quarter moving average, measuring annual growth rate by quarter as an average for the past four quarters, has been declining three quarters in a row:

Q2 2015: 2.74 percent
Q3 2015: 2.55 percent
Q4 2015: 2.43 percent
Q1 2016: 2.23 percent

These numbers capture a trend of economic slowdown, which is quite a different story from anything suggesting "strong economic data" is to be expected. 

Private consumption, the largest spending component of GDP, is also slowing down, though not as sharply (measuring again by four-quarter moving average):

Q2 2015: 3.20 percent
Q3 2015: 3.23 percent
Q4 2015: 3.11 percent
Q1 2016: 2.93 percent

The actual growth rate for the fourth quarter is 2.63 percent; in one year private consumption growth has dropped by almost 0.7 percentage points. 

Another important variable is Gross Fixed Capital Formation (GFCF), also known as "business investments". In Q1 2016 GFCF grew by 0.4 percent year over year. That is by far the weakest number in four years. Investments in structures, which tell the story of businesses changing their facilities for production, storage and sales, has been negative for four of the five last quarters. 

The decline in structures investment means that businesses overall are experiencing over-capacity. Another variable sending the same message is investment in equipment, which has gone negative for the first time in at least four years. In inflation-adjusted numbers businesses purchased equipment for the same amount in Q1 2016 as they did in Q4 2014. 

Investments in intellectual property are still in positive territory, up 2.9 percent year to year in Q1 2016. However, that is also the weakest number in at least four years. 

The only investment category still in healthy numbers is residential construction: up 10.8 percent in Q1 2016. That is the strongest number in two-and-a-half years. 

However, residential construction does not create a boom in the economy. With all other relevant variables for both consumer spending and business investments pointing to a recession, it would be directly irresponsible of any economist to suggest that there are "strong economic numbers" ahead. For that reason it is also illogical to suggest anything but a marginal uptick in inflation. 

So if there are no macroeconomic reasons to raise interest rates, why did I suggest that the Federal Reserve should do so anyway this year...?

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