Should Rates Rise in 2015? Charles Evans Doesn’t Think So (Part 7 of 7)
(Continued from Part 6)
Problem with reverting to ZLB
In the previous article of this series, we discussed the scenario that would result if the FOMC (Federal Open Market Committee) were too early to squeeze the interest rate trigger. Reverting to the ZLB (zero lower bound) would hurt the Federal Reserve’s credibility, and its ability to manage monetary policy would come into question. But, more importantly, strong US economic growth would find itself on shaky ground.
Job growth needs to be more widespread than it is currently. Further, a wage rise has yet to pick up its pace, which would make policymakers more confident in inflationary pressures. Too early or too sharp a rate hike, relatively moderate wage growth, and pricier loans from lenders—like Wells Fargo (WFC), Bank of America (BAC), and JP Morgan & Chase (JPM)—would make consumers wary of getting a loan. This would negatively affect spending on durable and expensive goods.
Due to its lion’s share in economic output, a fall in consumer spending (XLY) would affect GDP (gross domestic product) growth, which, in turn, would affect the broad equity market (IVV).
Now let’s take a look at the other scenario: being too late in raising the interest rate.
Too late
The other scenario is that the FOMC would remain accommodative for long enough to give inflation enough time to rise very quickly. While a rise in inflation would meet with open arms, runaway inflation would present its own set of problems. The economy would start to overheat as economic growth rose above due to sustained accommodation.
Charles Evans is more comfortable with this scenario, given the downside risks to inflation and the possibility of deflationary shocks. According to Evans, even if inflation runs moderately above 2%, “the associated costs would be low.” Further, if inflation were to rise with a more-than-moderate pace, Evans suspects the FOMC would have enough time to address the problem with more-than-marginal increases in the federal funds rate. Given the inertia in inflation, the possibility of unchecked runaway inflation is very low.
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