No one doubts that interest rates will go back up again. The manipulation of lending policy is too important a tool in the Fed’s arsenal. It’s one of the most effective ways they can stimulate lending during times of capital crisis. Rates are so low right now that if an economic problem were to arise, the Fed would be largely powerless to intervene.
The central question facing the Federal Reserve Board of Directors is when to make the move. Inevitably, a decision to raise interest rates will cause short-term push back from investors, who would see companies as less able to finance their expansion. A rate hike will also cause a retraction in real estate development, which is a central driver of economic growth in many areas.
The Fed is looking at two key economic indicators to determine when the economy is strong enough to withstand an increase in interest rates: job growth and inflation. The importance of job growth is clear enough. Without more jobs, productivity drops off, undermining the economic health of the country. It appears that the Fed is looking for several months of sustained job growth, which didn’t materialize thanks to a surprise sluggish growth in June.
Inflation, though, is a more complex indicator of economic health. While too much inflation can be a problem for consumers, so can too little. Inflation is the pressure that keeps capital moving; without it, there’s no incentive to take risks in lending. If inflation stops, or worse, reverses, potential lenders tend to hoard cash and consumers hold off on purchasing. Demand drops, which can result in layoffs.
Deflation was one of the results of the 2008 financial crisis, so the Fed is trying to ensure the economy has regained enough strength to withstand the deflationary pressure of increased interest rates. The Fed’s target rate, 2% inflation, is still considerably higher than the current year’s average of around 1%. The Fed may soon have to revise its inflation targets unless economic performance changes radically.
For investors, this process of uncertainty can be frustrating. In many ways, it might be best to put the will they or won’t they tension to the side and focus on making smart, long-term decisions. Investors may miss out on a few dollars by not timing the market properly, but those losses will be wiped out by the gains of an intelligently-construct long-term portfolio.