Essay On The Fed’s Dilemma Over Interest Rate Increase

Summary

The Federal Reserve Bank of the US could come to a consensus whether the rate of interest in the US economy should be increased in June this year. The house was divided over the issue. Some officials were of the opinion that the rates should rise in June this year. But many of the members contended that the inflation rate is quite below the targeted rate of 2% and will continue to remain low due to the falling oil prices and the increase in the value of the US dollar. A good number of the officials feel that it would be proper to increase the rate in 2016. The recent report of the US Labor Department suggests that the rate of employment is falling. This again strengthens the position of the group who feels that rate should not be hiked in the near future. The Fed has set the interest rate to near zero from December 2008. The rates would be raised if the employment scenario improves and the inflation rate rises above the targeted rate of 2%. Another important issue is the strengthening of the US dollar. The higher dollar values have made imports cheaper and reduced the rate of inflation. The growth rate of the economy has also come down as the exports have decreased. Fed governor Jerome Powell has expressed caution over making a hurry in increasing rates as that may prove harmful for the economy. So the Fed has decided to wait and watch.

The Economic Theory Underlying the Article

The primary issue that the article deals with is the interest rates and inflation and also it brings in the issue of growth associated with inflation, unemployment and dollar prices. So let us discuss the macroeconomic theory behind the issue discussed in the article.
The rate of inflation depends on the interest rate that prevails in the economy. When the interest rate is high investments tend to fall so the aggregate demand falls leading to a fall in the price level and also the output level in the economy. This reduces growth and increases unemployment as we have shown in figure 1. Thus, a higher interest reduces the rate of inflation. So, the central bank tends to increase the interest rate when the inflation rate is high.
Figure 1
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We should also note that a higher interest rate reduces growth and increases unemployment. So in times of recession the central bank lowers interest rate.

The Theory Applied to the Issue Presented in the Article

The portion of the Fed officials have pointed out that due to lower prices of imports and the fall in the oil prices, the inflation rate will remain low for quite some time. So the Fed should not increase the rate of interest in June as that will lead to lower price level and employment. Concerns have also been expressed about the lower hiring rates that the Labor Department has reported. Higher interest rate will further increase the unemployment rate. Thirdly, the economy is facing retardation in growth this also calls for a lower interest rate. The article further points out that the rate has been reduced in December 2008 when the economy was going through a severe recessionary phase. The rate was maintained at near zero so that the economy can recover through higher investment and growth.

Evaluation

It is true that the US economy has recovered from the recession of 2008 and so the rates should be revised. But it should be noted that the current trends in the economy do not show that a rate hike will be ideal for the economy. The slowing growth rate, increasing unemployment and low rate of inflation calls for a low inflation rate. The Fed has taken a right decision not to increase the rate this June. The Fed should wait for the interest rate to rise, the growth rate to increase and the rate of employment to increase before deciding on a rate hike.

Conclusion

The situation discussed in the article points to the fact that the rate of interest in an economy is a very important and strategic tool and a strong monetary policy instrument that controls the inflation, growth and unemployment in an economy. So the decision to increase or decrease the rate of interest should be taken with care considering the current macroeconomic situation.

Works Cited

Hilsenrath, Jon and Ben Leubsdorf. "Fed Divided on June rate Increase, but Soft Data May Prove Deciding Factor." Wall Street Journal 8 April 2015. English.