The Federal Reserve’s move to raise its benchmark lending rate marks the end of era, putting in the past a rate that had been anchored around zero since December 2008.
The quarter-point hike in the federal funds rate on Wednesday, the first such hike since June 2006, marks the start of a return to economic normalcy.
The Fed’s benchmark rate influences loans as short as three months and as long as three decades. The hike represents the first of an expected slow but steady climb in borrowing costs across the economy over the next few years.
It also closes a chapter, where from 2008 until Wednesday, the Fed threw everything but the kitchen sink at the U.S. economy in hopes of staving off a financial collapse and later shorten the time it took to get back to recovery.
“The Fed’s decision today reflects our confidence in the U.S. economy, that we believe we’ve seen substantial improvements in labor market conditions,” Federal Reserve Chair Janet Yellen said in a news conference.
Aside from holding its benchmark rate near zero, the Fed also purchased trillions of dollars in government and mortgage bonds in a bid to drive down mid-term and long-term borrowing costs.
Going forward, it will be gradually more expensive for ordinary Americans to carry debt on a credit card, cost more to borrow to take out a car loan, and even raise the price of getting a mortgage for a new home.
That’s not a bad thing, however. It means the Fed thinks the U.S. economy, which remains in a long but sluggish recovery, is strong enough to handle progressively higher lending costs.
“Monetary policy is alive and coming out of its coma! Hallelujah! In effect, the U.S. economy is being upgraded from “critical” to “stable” condition,” said Stuart Hoffman, chief economist for PNC Financial Services in Pittsburgh. “Thus, Dr. Yellen and Co. are beginning to wean the economy off its meds as its health has improved and its prognosis is promising.”
Although expected, the Fed’s action was welcomed on Wall Street. Blue chips rose by 224.18 points to finish at 17,749.09 on the Dow Jones industrial average. The S&P 500 rose by 29.66 points to close at 2073.07 and the NASDAQ was up 75.78 points to end at 5071.13.
Economists expect the Fed to pause after the first rate hike to gauge its effects on the economy. And the unanimous Fed statement said as much.
“The stance of monetary policy remains accommodative after this increase, thereby supporting further improvement in labor market conditions,” the statement said, suggesting the Fed is in no hurry to quickly raise rates.
One reason for Fed caution is the recent behavior of inflation, or the rise in prices across the economy..
“Market-based measures of inflation compensation remain low; some survey-based measures of longer-term inflation expectations have edged down,” the Fed statement said.
In past economic recoveries, stronger growth fueled inflation, which was tamped down by raising lending rates, thereby slowing economic activity.
But the Labor Department’s most recent read of inflation Tuesday showed that over the past 12 months, the Consumer Price Index has risen by 0.5 percent, well below the 1-2 percentage range sought by the Fed. It is quite unusual to raise rates with such low inflation
Yellen addressed that concern, noting that the collapse in energy prices has helped keep prices from rising across the economy and that inflation is low because of “transitory factors that we expect to abate over time.”
One looming question is why inflation is so low given an unemployment rate at a healthy 5 percent, a rate Yellen expected to go lower in 2016.. A low jobless rate historically has meant that workers are in greater demand and can demand higher wages_ a process known as wage inflation. The Fed chief said “diminishing slack” in the labor market will give workers more bargaining power for wages next year, and Fed economists think the inflation rate next year will be 1.6 percent and 1.9 percent in 2017.
The midpoint expectation of Fed policymakers is that the benchmark rates will rise to about 1.5 percent by the end of next year, and 3 percent by the end of 2018. That’s a slower pace than the last time the Fed embarked on a rate-raising cycle, in a period between June 2004 and June 2006, when the Fed’s benchmark rate rose from 1 percent to 5.25 percent to slow a hot economy fueled by home-price growth, which proved unsustainable.
“The Fed will be relying on some new tools … to push interest rates away from zero, and financial market participants will be watching anxiously to see how well the new tools work,” predicted Dean Croushore, a former Fed economist who now teaches at the University of Richmond in Virginia.