Raising Interest Rates

This summer, Brazil’s inflation rate hit a 12-year high, notching upward to 9.56 percent. As a result, Brazil’s central bank has been forced to raise interest rates to 14.25 percent in an attempt to mitigate the impact of this towering inflation rate. The country’s economy—the seventh largest in the world—will shrink by 1.5 percent this year thanks in part to the disastrous high inflation.

With Brazil’s challenges not far from view, the U.S. Federal Reserve (Fed) is appropriately scrutinizing price indices at home. Once deflation or inflation gain momentum, the negative spiral becomes very difficult to solve, and the economic implications can be catastrophic. After seven years of the Fed artificially buoying the U.S. economy by lowering interest rates to essentially zero, and lengthy stretches in which it purchased $85 billion in bonds per month, the key U.S. economic indicators seem to finally be stabilizing sufficiently to justify short-term interest rates creeping back upward.

Before rendering a final decision on the matter, the Fed has taken into careful consideration several trends, like unemployment, gross domestic product (GDP), and the consumer price index (CPI). At first glance, a number of core factors seem to be doing quite well: the national unemployment rate is at a seven-year low of 5.1 percent, and GDP expanded 3.7 percent in the second quarter of this year.

However, the CPI, which measures price stability, has increased a mere 0.2 percent over the past year, and real wages have stagnated in the past 12 months, even decreasing in December 2014. Annualized inflation is well below the Fed’s 2 percent target.

The Fed appropriately fears price instability due to the extraordinary difficulty of reigning in the momentum of inflating or deflating prices. But critical variables affecting inflation have changed in parallel with our evolving global economy. Therefore, the Fed may be relying too heavily on antiquated economic philosophies and an overly narrow perspective insufficient to fully account for today’s economic realities in its decision process.

Recently, even in accelerated economic times, the U.S. hasn’t seen runaway inflation. In the last 20 years—encompassing the market euphoria surrounding the dot-com bubble and the housing bubble—annualized inflation in the United States has not exceeded 3.8 percent. Why? An increasingly-global economy has fostered sufficient competition and alternatives so that the threat of extreme inflation for the U.S. may no longer be the monumental concern it once was.

A risk that looms far larger than out of control inflation is that in raising interest rates, economic growth will halter, particularly in light of recent global challenges and volatility. In fact, the International Monetary Fund (IMF), an organization focused on global economic stability, publically urged the Fed to delay raising short-term interest rates until 2016. The IMF’s plea, interestingly, came even before the market challenges and devaluation of the yuan in China. The IMF’s concerns were rooted in a broader perspective of the still-fledgling economic stability worldwide. In addition to ongoing concerns in Europe, Russia, Brazil, and Japan, China’s recent struggles will not only decrease demand for U.S. exports but will likely increase imports, putting further pressure downward on prices in the United States.

Put simply: unbridled inflation in the United States is highly unlikely in the next few years.

Considering the delicate state of our economy, the Fed should not raise short-term interest rates in the immediate future. Only after our increasingly inter-dependent global economy stabilizes and inflation inches toward the targeted annual rate of 2 percent should the Fed consider raising interest rates—but it should do so without the speculative statements and carefully-worded hints that have spurred market volatility over the last year. Once conditions genuinely justify a rate increase, the Fed should be prepared to move, and move decisively. Until then, prematurely raising rates could inflict much greater economic harm than the risk of inflation justifies.

This post is part of an ongoing series of data-driven commentary on current events. It was originally published in the Zion’s Bank Economic Outlook Newsletter and the Deseret News.