Was the 12/17/2015 Hike in the Federal Funds Rate a Mistake?

Effective last December, the Federal Reserve raised the federal funds interest rate (short-term interest rate) by 25 basis points (¼ of 1%). This moved the federal funds rate from a range of 0% – 0.25% to a target of 0.25% – 0.50%. Though the rate increase was statistically insignificant, Fed watchers called the move historically significant. The federal funds rate hovered near zero for seven years with 2006 being the last time the Fed raised the rate.

The federal funds rate is the interest rate banks and other financial institutions charge each other for overnight, unsecured loans. Changes in bank prime rates typically parallel changes in the federal funds rate. Banks try to keep a constant spread of 2 to 4 percentage points between the federal funds rate and their prime rate. Hence, when the federal funds rate increases a quarter of a point, it’s expected that banks will increase their prime rate by at least a quarter of a point.

The prime rate is the interest rate that banks charge their best, most creditworthy customers. Many consumer loan product interest rates are also pegged to prime rates. These include variable rate mortgage and student loan products. Many credit cards are also tied to the prime rate and not the LIBOR rate – London Interbank Offered Rate.

The Big Banks Responded Rapidly to Increase Their Prime Rates

JPMorgan Chase, US Bancorp and Wells Fargo hiked their prime rates from 3.25% to 3.5% within minutes of the Fed’s announcement, as reported on December 16, 2015, issue at Forbes.com. Citibank joined the parade later that day with other big banks doing the same within days.

Most analysts agreed the immediate impact of the December hike on consumers would be negligible, with Fed Chair Janet Yellen saying as much during her rate hike press conference. They reasoned that many consumer loan products linked to the prime change rates yearly, such as variable rate mortgages and variable rate student loans. So, consumers would have a window of up to 12 months before actually feeling the pain of a rate hike. The exceptions are credit card interest rates, which change rapidly within the constraints of the CARD Act of 2009.

Though Fed watchers downplayed the immediate impact of the rate hike, many cautioned that it presaged a series of rate hikes, going as high as 1.25% by the end of 2016.

With Stock and Oil Prices Tanking, Can the Economy Support a Rate Hike?

In justifying why the Fed finally increased the federal funds rate, Fed Chair Yellen concluded her press conference stating: “it reflects the Committee’s confidence that the economy will continue to strengthen.”

Despite Chair Yellen’s happy talk about the state of the economy, economists of differing economic views feared the economy was not strong enough to support a rate hike. In its July 14, 2015, issue, Bloomberg Business reported that Nobel prize laureate Paul Krugman predicted the Fed would be wrong whenever they hiked the federal funds rate.

The Baltic Dry Index, a reliable measure of the economy, was at historical lows in November 2015, down 36 percent year to date, according to Bloomberg Business. The Baltic Dry Index from the London-based Baltic Exchange tracks prices of transported cargo, including grain, iron ore and coal. Therefore, it’s good barometer for tracking the volume of raw materials being shipped. When it’s down, it signals raw materials are not being made into finished products, which signals a decline in economic activity. When it’s at historical lows, it can be scary.

In the weeks following the Fed’s rate hike through the end of January 2016, Krugman proved to be prescient. The Wall Street Journal reported oil prices at below $30 a barrel on January 15, 2016. CNBC reported $2.5 trillion in stock market value wiped out through the first three weeks in January on January 25, 2016. The Telegraph of London reported on January 20, 2016, that Zhu Min, Deputy Director of the International Monetary Fund, feared the “January bloodbath” was a glimpse into the future if the Fed continued raising interest rates. Min was concerned the cost of borrowing would spread across the globe.

After the January Bloodbath, Is the Fed Reconsidering the Hike?

Though the Fed has remained mute about the collapse of stock and oil prices following the December rate hike, the January bloodletting apparently got the Fed’s attention. Bloomberg Business reported on February 2, 2016 the Fed is considering negative interest rates on U.S. three-month Treasury bills for extended periods of time. The Fed emphasized it’s a long way from moving into negative interest-rate territory, but the timing of the announcement is curious.

More information about factors that affect the economy can be found in the financial blog at PersonalMoneyStore.com.

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