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Be prepared for higher interest rates, Fed leader says (And this time, the prediction may really happen)

By Larry Dreiling

Standing just south of and high above the Liberty Memorial, the tower of the Federal Reserve Bank of Kansas City stands as a bastion of capitalism and, on occasion, contrarianism in American monetary policy. (Journal photo by Larry Dreiling.")

Historically, presidents of the Federal Reserve Bank of Kansas City have been consistently resistant to most forms of artificial stimulation of the United States economy.

When these presidents hold a seat on the Federal Open Market Committee (FOMC), which decides interest rates the Fed offers lenders, and in turn to the public, they often show their Heart of America roots by being a lone voice of dissent when the FOMC calls for such action as buying additional government securities to stabilize the economy.

The benefits of such purchases, KC Fed leaders have historically believed, outweighed the benefits, and a continued high level of monetary accommodation increases the risks of future financial imbalances and, over time, would cause an increase in long-term inflation expectations that could destabilize the economy instead of strengthen it.

The bank’s current president and CEO, Esther George, brings her background of growing up on a farm in northwest Missouri to the job. The sense of responsibility of farm chores is seen in George’s analysis, which is leaning—as one might expect—to a call for high interest rates.

“Getting interest rates off zero relatively soon is not only appropriate in terms of current economic conditions, but also will allow the Fed room to maneuver in the future should economic activity slow,” George told attendees at the KC Fed’s recent agricultural symposium.

Prior to that declaration and others on the challenges associated with the transition from an extended period of ultra-low rates to a longer-run monetary policy framework, George made some general statements about the nation’s and region’s economy.

“In the last year, we’ve seen some pretty substantial shifts in crop prices and livestock prices set new records. As I travel throughout the region, I often hear questions about what the economic implications might be for a sector that is increasingly global as we think about agriculture in this part of the country,” George said.

The economy has been growing for about five years, though the pace has been disappointing relative to past recoveries, George said, and although many had optimistic growth projections for 2014, there hasn’t been evidence of a significant bounce.

“The year began with an unusually harsh winter and businesses that substantially pared inventories, which shrank economic output in the first quarter,” George said. “Even so, the expansion remains generally solid, and I expect the economy will continue growing at a moderate pace based on the progress we’ve seen in labor markets and inflation expectations that remain stable.”

The labor market has made promising improvements with the unemployment rate dropping to 6.1 percent, its lowest point in nearly six years, and has declined over the past year at its fastest pace in three decades.

“Although some of this decline reflects a lower labor force participation rate, broader measures of unemployment have also improved rapidly,” George said. “For example, the unemployment rate including those working part-time for economic reasons or who consider themselves marginally attached to the labor force has fallen at its fastest rate on record.”

Inflation has firmed and its current pace is running slightly above FOMC projections, George said.

“One factor is the rise in food prices, which is cause for some concern because food comprises a large share of lower-income households’ resources,” she said. “Because these households spend nearly all of their income, any strain on their purchasing power from higher food prices results in weaker demand for other goods and services.”

George also cited that rents over the last three months have increased at their fastest pace since the end of the recession, despite the rapid building of new apartments. With slower demand for homeownership since the financial crisis and tighter mortgage credit conditions, the pressure on rental prices is likely to continue.

“Higher food and rental prices pose particular concern in the face of modest nominal wage gains,” she said. “Although some measures of wages are showing signs of moving higher, they are still barely outpacing inflation. At the end of 2012, average hourly earnings had risen about 1.5 percent year-over-year, but more recently have trended up to about 2.25 percent. As the labor market continues to strengthen, wages should begin to rise at a faster pace.

“By the end of next year, I expect the economy will continue to grow and bring the unemployment rate to near its longer-run normal level with rising inflation. Accordingly, it is entirely appropriate to normalize the stance of monetary policy by bringing the current asset purchase program to an end and laying the groundwork for less accommodative and more sustainable monetary policy.”

As a result, today’s economy, with a strengthening labor market and rising inflation, is ready for a more-normal rate environment, George said.

“Furthermore, waiting too long may allow certain risks to build, that if realized, could harm economic activity without room to adjust rates in response,” she said. “Such risks, for example, come from the financial system’s efforts to adapt to a near-zero interest rate environment.

“We have seen signs of reaching-for-yield behavior in the leveraged loan market, subprime auto lending and corporate bonds. In each individual market, perhaps, one can find a justification for the lofty asset price valuations and aggressive lending practices—nevertheless, taken together, these patches of potential excess paint a picture of financial markets that have become overly conditioned on high degrees of monetary accommodation.”

The low interest rate environment, George said, has also pushed some savers who have traditionally relied on safer assets into riskier securities. Questions are growing as to whether savers understand the risks associated with carrying a riskier portfolio, especially those who are retired or nearing retirement.

“Recently, a fair amount of attention to the issues of financial stability have been focused on whether monetary policy should address these imbalances with a rise in interest rates or whether regulation associated with the newly embraced macro-prudential approaches can suffice,” George said.

“Unfortunately, I expect neither offer perfect solutions. As I have noted in previous remarks, monetary policy cannot distance itself from the incentives it has created and the effects of rates that are too low for too long, and macro-prudential supervision, for all its promise, is not yet a proven cure for excess risk-taking.”

George said weaning markets off the many support mechanisms now in place will be challenging. But policy needs to confront this challenge. Otherwise, expectations of ultra-low rates will persist and may become further entrenched.

“Expectations of low rates often go hand-in-hand with expectations of low inflation and low growth,” George said. “While low rates can benefit growth by encouraging households and firms to borrow and invest, this interest rate channel is only one aspect of monetary policy and has proven to be less effective in the face of a deleveraging economy. And by keeping rates unusually low, policymakers may signal pessimism that the economy is not strong enough to begin moving to a more-normal rate environment.

“Moving rates up in line with improving economic fundamentals not only helps foster price stability in the longer run, but also sends a clear message that the Fed sees the economy as finally moving past the damage inflicted by the crisis.”

So what does that mean for short-term interest rates? Should consumers consider buying a car or refinancing their homes now? According to George, short-term interest rates and the effects of quantitative easing have been designed to spur longer-term business development and allow consumers to better afford mortgages and durable goods—ranging from tractors on the farm, to cars in the garage, to washers and dryers in the laundry room.

“There is a point where zero interest rates will necessarily have to be a thing of the past,” George said. “The economy today is showing the sort of strength that warrants preparing markets and the public for that eventuality.”

Larry Dreiling can be reached by phone at 785-628-1117 or by email at

Date: 8/18/2014


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