The Fed’s Dilemma

Nicolas Torres
Aug 22, 2017 · 3 min read
Janet Yellen

Most business school graduates are familiar with the infamous “Prisoners’ Dilemma.” Currently, the Federal Reserve finds itself in somewhat of a similar situation, only the stakes are much higher than ratting on your accomplice.

This dilemma started to form when Janet Yellen, the Fed chairwoman, and the other Fed members made the decision to keep interest at zero for a substantial period of time following the financial crisis of 2008. What was their reasoning for this? It could have been an attempt to adhere to what other countries were doing, as much of the world was lowering their rates while some (Japan) were implementing NIRP. (Negative Interest Rate Policy) Another possible reason for this decision was a fear of sparking another financial meltdown. The financial crisis caused many individual investors to lose trust in the U.S. financial system.

http://www.gallup.com/poll/182816/little-change-percentage-americans-invested-market.aspx

Americans thought that investing in individual stocks or forfeiting part of their paycheck to their 401(k) was too risky. In order to calm that fear, the Fed could have possibly intended to keep interest rates at or near zero in order for the average American to regain their confidence to invest back into their country.

What is the big deal about this decision by the Fed? Well currently, the Fed has brought the Federal Funds Rate to a mere 1.25%.

https://fred.stlouisfed.org/series/DFEDTARU

Based on the incoming jobs data, normal procedures would call for the Fed to continue to raise rates as more and more Americans join the workforce. However, another problem arises when studying the Phillips’ Curve. The normal correlation between an decreasing unemployment rate and an increasing inflation rate no longer exists. As smart as the Fed officials are (or pretend to be), nobody is really capable of why this is happening.

The Fed now finds itself in an interesting dilemma. They can either go against protocol and raise interests rates while turning a blind eye towards their disappointing inflation data, or they can simply be cautious and hold rates steady until inflation picks up. Obviously, there are consequences with both decisions.

If the Fed decides to raise rates anyways, they could potentially set off a shock that would rock financial markets all over the world. Investors mostly expect the Fed to hold off on raising rates due to the inflation data. A sudden increase in the Federal Funds rate would be a shock to investors and most likely send markets tumbling.

On the other hand, if the Fed tries to be too cautious, they will find themselves creating a financial bubble. As rates stay low, companies are able to take advantage of this and thrive financially. This causes valuations and asset prices to inflate to worrisome figures. As the prices go higher and higher, they will only fall that much further when the Fed realizes it has made a mistake waiting so long.

What should you expect? With one of the worst recessions in history in our review mirror, I would expect the Fed to remain being cautious with raising the Federal Funds Rate. When the time finally comes for them to raise the rates back where they belong, markets will have to make major adjustments.

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