Why December Is Looking Likelier for the Fed to Raise Interest Rates

One of these days, the Federal Reserve tells us, it will decide to raise interest rates.

The announcement will be akin to a doctor’s decision that a patient is well enough to be gradually taken off medication. The thinking inside the Fed is that the economy is finally healthy enough that borrowing costs should return to more “normal” levels to help keep future inflation from accelerating too much.

But it is a moment with challenges. It could send markets into a tizzy (if past experience is any guide), lead to a slower economic recovery and make it harder for workers to press for higher wages. For savers, it could signal higher returns, but those borrowing to buy a house or a car may soon have to pay more.

Nearly seven years ago the Fed put its benchmark interest rate close to zero as a way to bolster the economy. And for months now, officials have said they might raise rates by the end of 2015. Recent statements underscore an intention to act at their final meeting of the year, in December.

It’s a “liftoff” – to use the Fed’s own term – that’s getting the kind of attention that space aficionados once lavished on NASA rockets. Fed officials left rates unchanged after meeting in October, but when they do make their announcement, it will have lasting consequences.

The last time the Fed raised interest rates, in June 2006, Facebook was mainly for college students and had one-tenth the users of Myspace.

Since Dec. 16, 2008, the Fed has kept its benchmark interest rate at a range between zero and one-quarter percent. The move was announced in the gloom of the longest recession since World War II, as jobs were being squeezed out of the economy like water from a sponge. Ten days earlier, the government announced the United States economy shrank by 533,000 jobs in the previous month, the largest one-month loss since 1974. (The number was actually far worse; it was later revised to a loss of 765,000 jobs.)

Federal Funds Target Rate

This graphic shows the Federal Funds Target Rate previous to the December 2008 rate change; since then, the upper limit of the Federal Funds Target Range has been zero to 0.25 percent. Explore More Graphics »

By pushing the rate to the floor, the Fed went as far as it could with its main tool for guiding the economy: setting a target range on the federal funds rate, or the amount banks charge each other for overnight loans. The rate is set by the central bank through its buying and selling of short-term Treasuries – i.o.u.s from the government – mostly in trades with commercial banks.

The Fed used other means to prop up the economy, notably buying mortgage securities and other bonds to help bring down long-term rates further. The strategy, known as quantitative easing, encouraged more borrowing and lending, led to a stock market boom and, the Fed contends, eventually helped bring about a sustained economic expansion. Convinced that it has done as much as it considers prudent, the Fed is no longer expanding the size of its balance sheet, which reached $4.5 trillion.

Still, while the economy has rebounded, certain aspects of the recovery – like the housing sector, work force participation, and hourly wages – are spotty at best. Since March, Fed officials have said they expect to raise interest rates sometime before the end of the year.

The action will most likely be taken on Dec. 16. That’s when the Federal Open Market Committee, the Fed policy-making group that sets the target rate, concludes its next two-day meeting. Janet L. Yellen, the Fed chairwoman, is scheduled to hold a news conference that afternoon. (In the unlikely event that policy makers take no action, the next meeting dates are Jan. 26-27 and March 15-16.)

Confidence in jobs growth has replaced worries generated by last summer’s turmoil in the global economy. The slowing Chinese economy and devaluation of the renminbi, the slumping price of oil, jarring downturns in the global stock markets had all prompted questions over when will be the best time for the Fed to raise interest rates.

Ever since March, when the Federal Open Market Committee dropped the word “patient” from its stance on raising the benchmark rate, Fed policy makers have used a standard line to describe the conditions that would warrant a rate increase:

“The committee anticipates that it will be appropriate to raise the target range for the federal funds rate when it has seen further improvement in the labor market and is reasonably confident that inflation will move back to its 2 percent objective over the medium term.”

Jeffrey M. Lacker, a member of the Federal Open Market Committee, has been vocal about the need to raise rates sooner rather than later. In a speech in September, he said:

Some might argue that as long as inflation is close to 2 percent we have a free pass — we can keep supporting the real side of the economy with low rates until inflation rises. But if, as I’ve argued, the real side of the economy calls for a higher interest rate, then there is a real danger associated with this strategy. Inflation is a lagging indicator, and the forces that lead to rising inflation can build up before they are apparent in the data.

On Sept. 17, after a two-day meeting, the committee decided not to change rates, citing market worries:

“Recent information on real U.S. economic activity was generally stronger than expected, but equity prices declined, the foreign exchange value of the dollar appreciated further, and indicators of foreign economic growth were generally weak.”

On Oct. 12, Lael Brainard, a member of the Federal Reserve’s Board of Governors, argued that the central bank should continue to exercise restraint in raising rates.

“I view the risks to the economic outlook as tilted to the downside. The downside risks make a strong case for continuing to carefully nurture the U.S. recovery — and argue against prematurely taking away the support that has been so critical to its vitality.”

But since the robust job numbers for October, more Fed officials have made public statements that appear to support raising rates in December. William C. Dudley, the president of the Federal Reserve Bank of New York, who opposed raising rates in September, said on Nov. 12 that his reasons for hesitation had receded.

“I see the risks right now of moving too quickly versus moving too slowly as nearly balanced.”

Speaking on the same day, Charles Evans, president of the Federal Reserve Bank of Chicago, who has previously opposed a rate increase this year, said “the precise timing for the first increase in the federal funds rate is less important to me than the path the funds rate will follow over the entire policy normalization process.” He, like other Fed officials, stressed the need for a very gradual increase in rates.

And on Nov. 18, the Fed issued minutes of its October meeting that showed that most officials think the economy will be ready for higher rates. The document stated:

“While no decision had been made, it may well become appropriate to initiate the normalization process at the next meeting.”

In recent months, there has seemed to be no lack of analysts, experts and would-be Fed chiefs ready to tell the Federal Open Market Committee what it should do. A sampling follows:

“With credit becoming more expensive, the outlook for the Chinese economy clouded at best, emerging markets submerging, the U.S. stock market in a correction, widespread concerns about liquidity, and expected volatility having increased at a near-record rate, markets are themselves dampening any euphoria or overconfidence. The Fed does not have to do the job. At this moment of fragility, raising rates risks tipping some part of the financial system into crisis, with unpredictable and dangerous results.” — Lawrence H. Summers, former Treasury secretary, writing in The Financial Times (Aug. 23)

The Fed seems intent on raising the rate “if only to prove that they can begin the journey to ‘normalization.’ They should, but their September meeting language must be so careful, that ‘one and done’ represents an increasing possibility – at least for the next six months. The Fed is beginning to recognize that six years of zero bound interest rates have negative influences on the real economy.” — William H. Gross, a co-founder of Pimco who now manages a fund at Janus Capital, writing in his September Investor Outlook (Sept. 2)

“Central bank communications can be a tricky business.”

Stanley Fischer, the vice chairman of the Fed, was referring to a remark in 2013 by Ben S. Bernanke, who was the Fed chairman at that time.

Mr. Bernanke, noting improvements in the economy, said in a news conference that the Fed’s policy makers believed the time would soon come to begin tapering the bank’s “quantitative easing” asset purchases.

The announcement had an instantaneous impact on markets that were caught off-guard after having grown accustomed to a Fed with an open wallet.

While the news conference was still underway, bond prices plummeted and stocks sank. As Gennadiy Goldberg, an analyst, said at the time: “As soon as you give the market anything to chew on, they are going to tear the limb off.”

Ms. Yellen and other Fed officials have learned their lesson from that episode, and have gone out of their way to provide plenty of advance warning about the coming rate increase. When rates eventually rise Ms. Yellen wants to make sure investors saw it coming. She has also made clear that future rate increases will be gradual, about one percentage point per year.