Can the Fed Reserve continue to keep rates super-low with 3% GDP growth?

“In the second half of this year, however, the market is likely to begin questioning when the Fed is likely to commence raising rates, even if the actual event is some time away.”

That’s a comment made in reference to how US bond yields would react going forward by Manpreet Gill, a senior investment strategist at Standard Chartered, according to a CNBC report.

It’s an interesting comment and one that got me thinking.

If everything goes according to script, the US economy is likely to expand by or close to 3% this year. Can the Federal Reserve continue to keep short-term interest rates ultra-low with that kind of growth?

Earlier statements by the central bank have highlighted the fact that the current target range for the federal funds rate (its main policy rate) at 0-0.25% well past the time “that the unemployment rate declines below 6-1/2 percent, especially if projected inflation continues to run below the Committee’s 2 percent longer-run goal.”

In addition, the Fed has pledged to interest rates at or around zero until mid-2015.

But that could become an increasingly difficult promise to keep.

For one thing, the unemployment rate is already down to 6.6% (although partly because of a slide in the labour participation rate, which refers to the number of people having a job or looking for work. A lower participation rate suggests more people are dropping out of the job market.)

For another, the US economy is recovering quite remarkably. In the last quarter of 2013, economic activity expanded by 3.2% from the previous quarter. The outlook for 2014 is also buoyant, despite a possible slump in GDP growth in the first quarter.

It everything goes according to script, US GDP growth in 2014 will be above the 20-year moving average annual GDP growth rate of 2.5%. It will also be much higher than the 10-year moving average of 1.7%, according to data provided in this blog post by John Ross, a senior fellow at the Renmin University of China.

In general, the long-run average growth rate of the US  economy is believed to be between 2.5% and 3%, according to a New York University’s Stern School of Business webpage.

The long-run average growth rate is the rate at which an economy can grow without stoking rapid inflation.

The long-run growth rate of the US economy has been declining in recent decades, as is the case with several other developed nations.

To be fair, after a near-economic collapse in 2008, it’s only natural that when the US economy rebounds, growth will likely rise above the long-term trend rate in the short term. 

However, after that, growth should typically ‘revert to the mean’ (move towards the average trend rate of growth).

The point here is that keeping rates super-low when the economy is expanding at an above-trend growth rate or even while reverting to normal growth rates will become unsustainable as worries about inflation will increase. For now, inflation is not  a concern. 

And yes, the impact of the ongoing Fed tapering (winding down its asset purchases) will also have be considered.

So far, the Fed has focused on inflation and labour market conditions to take interest rate decisions.

But if the economy continues to grow at a steady clip, it will not be able to ignore that fact going forward when it estimates the timing of a short-term interest rate hike.

So as much as monetary policy makers insist that they won’t touch interest rates, they may have to soon start thinking about them.

Of course, keep in mind that rates are only expected to ascend modestly. In December, a survey of Fed officials showed that a majority forecast rates to stay at or below 0.75% through the end of 2015, reported the Wall Street Journal.

A majority of policymakers also said rates will stay below 2% through the end of 2016 (assuming inflation stays subdued), the report added.

We could get some insight into Fed thinking later today, when new Fed chair Janet Yellen presents her first testimony before Congress.

It’s very likely the well-known dovish economist will emphasise a continuation of Bernanke’s policies and not attempt to rock the boat.

While interest rates hikes are not on the agenda right now,  if the US economy continues to pick up speed, they could become a topic of discussion for the central bank later in the year.

Even if the actual event (raising interest rates) is some time away.

[Image Credit]

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