Fed Officials See Strong Economy Justifying Interest Rate Rises

By Anonymous

WASHINGTON—The Federal Reserve has become the center of attention at the White House and on Wall Street for rising interest rates that helped knock stocks off balance this week.

Inside the central bank, however, officials see broader forces—including declining unemployment, inflation’s return to normalcy and a fast-growing economy—pushing interest rates higher.

Federal budget deficits, driven by tax cuts and spending increases, are also at play. Larger deficits mean the U.S. Treasury is issuing more bonds and bills to finance the shortfall, prompting investors to demand a higher interest rate in return.

President Trump this week amplified his criticism of the Fed, saying its rate increases were “out of control” and that the increases were making it harder to finance the federal deficit. He said he wouldn’t fire Fed Chairman Jerome Powell—which the law only allows him to do for cause—even though he is disappointed in the central bank’s behavior.

The Fed has been raising short-term interest rates since December 2015 and for many months has telegraphed further increases. Many investors believe “rates have to go up because the economy is good, and the Treasury is issuing a lot more debt,” said Roberto Perli, an analyst at Cornerstone Macro.

Higher rates are meant to prevent the economy from overheating and causing inflation or a financial bubble. After holding rates near zero following the 2008 financial crisis, the Fed has raised its benchmark rate eight times since December 2015, including three times this year. Last month, officials boosted the rate to a range between 2% and 2.25%. But it remains low historically: It averaged 4% over the 1990s and 2000s.

Mr. Trump worries that higher borrowing costs will slow economic growth and cool the stock market.

President Trump called the Federal Reserve’s recent interest-rate increases “a mistake,” suggesting that the central bank was to blame after Wednesday's stock-market plunge. Photo: AP Images

The Fed is responding to a broad constellation of forces that central bank officials believe leave them with few alternatives but to keep lifting rates, albeit at a slower pace than they have in the past.

The U.S. unemployment rate dropped to 3.7% in September, its lowest level since 1969, and inflation this year has returned to the Fed’s 2% target after many years of falling short. Fed officials project the jobless rate will decline to 3.5% by December.

With unemployment low and inflation nearing normal, Fed officials figure interest rates need to return to normal as well to prevent the economy from overheating.

What’s normal? Projections from Fed officials last month suggest many of them think a rate around 2.75% or 3% would mop up much of the added stimulus the Fed provided to the economy after the last recession. The central bank would need to raise rates at least again in December and next March to get there. Fed officials see themselves getting to 3.375% by the end of next year.

One latent source of tension between Mr. Trump and the Fed is a disagreement over how the economy will respond to tax cuts and federal spending increases enacted over the past year.

The White House says tax cuts will lift the economy’s growth potential, positioning the Fed to allow the economy to run hotter with lower rates. The Fed isn’t so sure and wants to proceed with caution.

Central bank officials worry that fiscal stimulus will hit the economy when it already faces resource constraints, which could lead to more inflation.

The Fed’s current strategy of quarterly rate increases is trying to balance against the risk of two potential policy mistakes.

“The first risk is that we move too quickly, and we prematurely end the expansion and inflation never gets solidly back to 2%,” Mr. Powell said last week. “The alternative risk is that we move too slowly and the economy overheats, and that can show up in the form of too high inflation or financial market imbalances.”

For now, inflation doesn’t appear to be a problem. U.S. consumer prices rose only slightly in September. Core prices, which exclude the volatile food and energy categories, were up 2.2%, the same rate as in August. That should translate into inflation of around 2% in September using the Fed’s preferred gauge, according to economists at Morgan Stanley.

Budget deficits represent a related source of tension. The Trump administration has said stronger growth would yield higher government tax revenue, offsetting the decline in receipts from lower tax rates.

That is yet to occur, and has sent the federal deficit to unusually high levels for an economy that isn’t in recession. Last week, the Congressional Budget Office projected the deficit stood at 3.9% of gross domestic product for the fiscal year that ended last month, up from 3.5% in the fiscal prior year and 3.1% two years ago.

Higher rates will further boost the deficit by raising federal debt-service costs. “I’m paying interest at a higher rate because of our Fed,” Mr. Trump said in an interview Thursday on Fox News.

The Fed may not be troubled about this week’s stock market selloff because its officials have been uneasy about historically lofty asset valuations for the past year and attentive to the risk of another financial bubble.

When the Fed raises its benchmark rate, it aims to tighten financial conditions, which are reflected in the prices of stocks, bonds, real estate and other assets. If asset prices continue to rally as rates rise, that could suggest the Fed has to raise borrowing costs even more to keep the economy on an even keel.

Already, there are some signs the Fed’s rate increases have begun to cool some parts of the economy. The 30-year mortgage rate is close to crossing 5% for the first time in seven years, which is robbing home buyers of purchasing power and forcing sellers to raise prices less aggressively or even to lower them.

Write to Nick Timiraos at [email protected]