Why The Fed Will Raise Interest Rates Next Month, And Why It Probably Shouldn’t

Fed Interest Rates

The first Friday of every month has special meaning for economics nerds all over America: it’s the day the Labor Department releases employment data for the previous month.

In recent years, it’s been particularly important as an indicator of how well the American economy is recovering from the Great Recession. The latest numbers continue the long downward trend for the unemployment rate, hitting an Obama-era low of 5%.

That’s certainly good news: fewer people are unemployed (although it’s worth asking how many have given up and dropped out of the labor force, and calculations, altogether).

But it could also mean slightly worse news for the broader economy. Because while the labor numbers are looking good, that means the Fed is even more likely to raise interest rates by the end of the year.

Why the employment numbers are so good

October saw 271,000 jobs added to the U.S. economy, a far better month-to-month change than originally expected. It was an all-around excellent jobs report, the best of the year and one which pushed the unemployment rate down to a healthy 5%.

That’s a good figure because in a properly functioning economy there are always people in between jobs; 100% “full employment” is impossible (in a non-planned economy, anyway). It’s also the lowest the unemployment rate has been since 2008, the height of the financial crisis.

And it continues an upward trend for the labor market, despite disappointing data in the previous two months. But as FiveThirtyEight pointed out, those were probably outliers.

Other indicators jumped as well, with wages rising 9 cents an hour (a 2.5% increase from a year ago). That means wages are rising faster than inflation, for now. But if wages continue to rise, inflation will almost certainly follow suit. That’s also a good thing! Because inflation means people have jobs, are making money, and essentially bidding the prices of goods upward. We’ll get back to that when we address the question of how this affects the Federal Reserve’s decision-making process.

Ultimately, higher wages could mean the labor market is becoming more competitive. That’s great news for workers – as well as those who want to be workers but might have dropped out of the market or are forced to work fewer hours than they would like.

Which brings us to the one caveat: the percentage of the eligible population actually participating in the labor market remains at a near four decade low, 62.4%. With fewer people active in the labor force, that could skew the calculations.

But a more competitive labor market, with rising wages, could encourage those who have dropped out to jump back in. It could also make a dent in the number of underemployed workers – those who aren’t able to find full-time employment.

Why this makes a rate hike more likely

When it decided to stand pat last month, the Federal Reserve said that future decisions would be based on “progress – both realized and expected – toward [the Fed’s] objectives of maximum employment and 2 percent inflation.”

“Maximum employment,” in economics terms, is around 5%. So the U.S. economy seems to be there, or very, very close to what the Fed would want to see.

And, as noted earlier, if wages are going up then inflation should be close behind.

That all seems to point to a rate hike when the Fed meets in December. Chairwoman Janet Yellen said as much at a House hearing last week when she described a December rate hike as “a live possibility” should “incoming information” back up the Fed’s expectations of a strengthening economy. Friday’s data makes it even more lively.

That was backed up over the weekend when San Francisco Federal Reserve Bank President John Williams said increasing rates sooner would ensure a “smoother, more gradual process of policy normalization.” And after Friday’s news, Chicago Fed President Charles Evans said “what we’re likely to get into discussing before too long is what’s the path of the rate increases.”

But more importantly, Friday’s report bolsters the case the Fed has been making for a while now. It’s the one Yellen made on Capitol Hill. If things are obviously going well, and the data shows a long-running trend in that direction, then why should a policy of zero rates intended to counter recessionary forces continue?

And, as Williams pointed out, the “process of normalization” has to begin eventually. Doing it sooner rather than later might be a good idea. Markets have been waiting so long for an increase that actually doing it might introduce a bit of stability into the process. That persistent anticipation has made investors jittery; beginning the process of raising rates could finally wean markets off years of easy money and shift worries away from Fed policy-making. In other words, rip the band-aid off already.

Or, to use another metaphor: take the economy off life support. It’s obviously doing fine.

Why a rate hike might be a bad idea

Or is it?

Vox’s Matthew Yglesias makes the case for a prolonged period of low interest rates, with the goal of driving an economic “boom”:

Low interest rates are part of the fundamentals of the American economy, and have been for years now. One thing that happens in an economy that has low interest rates is that money flows into the hands of entrepreneurs and innovators rather than being tied up exclusively in financing government debts and plain vanilla mortgages.

Yglesias argues for keeping rates low until inflation becomes a problem – which, he says, is the whole point of raising interest rates. So far, inflation doesn’t seem to be a threat. The time to raise rates, then, is when it does become a threat; doing so before that point could cut off further growth and hurt the economy. If that happens, and growth starts to slow again, then the Fed could find itself having to backtrack.

Or, to continue the metaphor, are we really sure the wound is healed before we rip that band-aid off? Maybe it’d be best to give it a bit longer and keeping it on doesn’t seem to be hurting anything.

American central bankers, led by Janet Yellen, certainly seem to think the economy is heading in the right direction. The indicators all seem to be pointing that way. But at this point, a rate decision is still a gamble. The data looks good, but still not anywhere close to problematic. So the easier option would be holding rates steady until inflationary pressures – rising wages and prices – become more obvious and the economy threatens to overheat.

There’s also the problem of all those aspiring workers who dropped out of the labor market altogether. John Cassidy of The New Yorker argues that “the underlying state of the labor market isn’t as strong as the headline figures suggest,” and that raising rates now might write that group off entirely. Cassidy even notes that the participation rate has continued to decline this year and that the 2015 unemployment rate including underemployed and discouraged workers is higher than it was in December 2007.

If so many people are still left out, years into a technical recovery, that might mean the broader economy is not only far from overheating but that it hasn’t really begun to warm up in the first place.

But despite all that, Fed officials have been signaling that the time is right for the first rate increase in years. Barring a big swing the other way in the November jobs report, it’s hard to see the Open Market Committee failing to raise rates when it meets in mid-December.