The U.S. Federal Reserve has ripped off the worn Band-Aid of near-zero interest rates. It's better to get it over with. The key from here – for the U.S., for Canada, for everyone – is how well the scars underneath have healed.
After raising the most important interest rate in the world for the first time in nearly a decade, Fed Chair Janet Yellen did her best to insist that it wasn't that big a deal. "We have very low rates and it was a very small move," she told a press conference, following the Fed's quarter-percentage-point hike of its federal funds rate, to a new range of 0.25 to 0.50 per cent.
Sure it's a small step. Kind of like Neil Armstrong took a small step.
Last time the Fed raised rates, the iPhone didn't exist. George W. Bush was still in the White House. Mike Duffy was still a TV reporter. Large swaths of financial market professionals have gone their entire careers without witnessing a Fed rate hike. It's practically the Halley's Comet of economic events. How they react to the sight is anyone's guess; the news of the hike sent spasms through stock, bond, currency and commodity markets on Wednesday, despite the fact that the Fed had telegraphed its intentions for months.
It may be a puny increase of an even punier rate, but it still marks a momentous turning point. The Fed hasn't touched its key federal funds rate since dropping it to essentially zero in late 2008, in the throes of the financial crisis. The long, painful recovery of the U.S. and global economies has never operated in anything other than a Fed at essentially zero.
Of course, the Fed wasn't exactly sitting around twiddling its thumbs and playing computer solitaire all that time. It did three rounds of quantitative easing. It did forward guidance. It did Operation Twist (sort of a QE-light, in case you've forgotten). It expanded its balance sheet by a few trillion dollars.
But it's not quite the same thing. Interest rates are a central bank's biggest weapon, and the Fed has the biggest guns in the world. It manages the world's biggest economy and a currency that is held in reserve more than all other currencies combined. Even a single shot makes one hell of a bang.
The fact that the first rate hike is finally over with is a positive. It removes one uncertainty that has been no small contributor to the financial market volatility of recent weeks. And as Ms. Yellen told the American public in her press conference, it is a vote of confidence in the strength and sustainability of the U.S. economic resurgence. For those of us sitting in Canada, where the economy is counting more than a little on U.S. growth to propel an export-led resurgence of our own, that's a pretty important signal.
Maybe more importantly, the Fed found itself standing at a window of opportunity to finally get rates up from their near-zero floor, and it jumped through while the jumping was good. In an uncertain global economy, having the world's most important central bank with no room to reduce rates in the event of another serious economic downturn is not a comfortable position, for anyone. The collar constraining global monetary policy just loosened a little bit.
Ms. Yellen is right that raising rates from effectively zero to not far from zero shouldn't, in itself, be a particularly significant impediment to the U.S. growth story. Rates are still extraordinarily inviting to borrowers, highly stimulative to domestic spending and consumption – which is by far the biggest driver of U.S. economic growth. Household consumption accounts for 70 per cent of GDP.
Still, U.S. rate policy doesn't exist in a vacuum. It's probably fair to expect that the impact of a Fed hike will be magnified by the fact that pretty much every other central bank in the world that matters is headed in the opposite direction. Indeed, the anticipation of a Fed hike has already applied more brakes to the U.S. economy than higher interest rates themselves probably will. This rate-divergence story has sent the U.S. dollar soaring, and the fallout has been a rapid erosion in demand for U.S. exports, as well as deeper declines in commodity prices, which trade globally in U.S. dollars. Just hours before the Fed rate hike, the U.S. industrial production report for November bore those wounds, posting its third-consecutive monthly decline.
In many observers' minds, those weaknesses exposed at the mere idea of a Fed rate hike, coupled with the weak economic prospects in many other major economies outside the United States, were strong arguments against a rate increase at this time. The Fed, it appears, was convinced otherwise by the unshakeable momentum in its labour market, one of its most important policy drivers. This initial rate hike will test whether the U.S. economic recovery really does have the legs to keep running in a rising rate environment.
From here, though, the Fed will want to be very cautious indeed. It has indicated that it intends to proceed slowly with gradually lifting rates to more normal levels, but the range of expectations among members of its policy-setting committee nevertheless suggests that its key rate could go up another full percentage point in the next year. From where we have been sitting for the past seven years, that's a lot.
The next move, then, should depend in no small part on how well the financial markets and the U.S. and world economies deal with this first hike. If this one proves hard to swallow, the next one could be a choking hazard.