Economics, the Federal Reserve & Interest Rates

Economics, the Federal Reserve & Interest Rates

During the Federal Open Market Committee (FOMC) meeting of December 13-14, the Federal Reserve decided to raise the target of the federal funds rate (interest rate) to a range between 0.5% and 0.75%. Though still a modest target range, this is the first interest rate raise since 2015, when the target range was established between 0.25% and 0.5%. Furthermore, the interest range between 0.5% and 0.75% is the highest rate that the Federal Reserve has agreed upon since the onset of the 2008 financial crisis. The first reason that Chair Janet Yellen gave for the long-awaited raise in interest rates is the decline in the unemployment rate, driven mainly by the more than 2 million jobs that have been created in the United States during 2016. Other important reasons for raising the target interest rate are the overall increase in household spending and the positive signs of economic growth. Similarly, over the short-term, there has been an increase in consumer income and there is optimism about the future of the economy.

Nevertheless, the key factor behind the interest rate change is the increase in the Consumer Price Index (CPI) and consequently the real inflation rate that is expected during 2017. Given the recently agreed upon reduction in global petroleum output between OPEC and non-OPEC producers, energy prices are experiencing a significant increase. Even though the full impact of the oil supply reduction agreement cannot yet be assessed, the reality is that energy prices will be higher, at least during the coming months. Even if the agreement amongst oil producing nations is short-lived, a couple of months with lower outputs levels from major producers will serve to reduce the current levels of oil stocks throughout the world, which are a main driver behind the low market prices that have prevailed the last two years.

Because of these dynamics within the oil industry, the CPI and inflation will increase to a level that is closer to the 2.0% target rate established by the Federal Reserve. Therefore, in order to mitigate the long-term effect of inflation on savings and earnings, the interest rate needs to be increased as inflation rises. Furthermore, the interest rate increase strengthens the position of the US dollar (USD) within the foreign exchange markets. Recently, the valuation of the USD had been slightly weakened against the national currencies of oil producing countries because of the supply reduction agreement.

As the President elect of the US and his administration prepare to take office on January 20, global economic sentiment and trends will certainly evolve because of the new policies that will be implemented. Likewise, the tenure of Chair Janet Yellen at the head of the Federal Reserve is ending during the first weeks of 2018 and the incoming President could name a successor who advocates for different monetary policy measures. Nevertheless, as the US economy continues moving forward and recovering significant growth, the interest rate set by the Federal Reserve is expected to reach its intended long-term target around 3.0%.

(Read more about how Oil Producers seek to Strengthen Industry Profits)