Suddenly, everyone is scared about interest rates

What now?
What now?
Image: Reuters/Lucas Jackson
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US Federal Reserve chair Janet Yellen is scheduled to step down tomorrow from her eight years at the helm, and for most of her tenure, interest rates remained at historic lows. She finally gave into clamors for tightening in 2015 and raised rates. The Fed has raised rates four more times since, and initiated the unwinding of its $4.5 trillion balance sheet. Markets, anticipating these policy changes, stayed calm.

Suddenly today (Feb. 2) the S&P 500 dropped over 2%, and the Dow plunged 666 points, its worst day since Brexit. No one is entirely sure what’s going on. The unemployment rate has continued to fall, as the US adds more jobs each month, and economic growth outlooks are robust. Wages are increasing, too.

It seems that Janet Yellen’s farewell, and the Fed’s more aggressive inflation expectations, have left markets skittish.

In general, business owners like low interest rates. Even President Trump, who nominated Jerome Powell to succeed Yellen, has admitted that her policies have been good for the markets. When the Fed lowers the federal funds rate—the rate at which it loans money to banks—it makes money cheaper.

Banks can borrow from the Fed more easily, which then allows banks to lend to businesses and individuals more cheaply. Other rates, like mortgage rates, auto loan rates, and corporate loan rates, too, fall. In theory, cheaper loans  should lead to more business investment. As businesses spend more, company productivity rises, and so do share prices.

A period of accommodation that’s seemingly endless, however, isn’t good for markets. Low interest rates signal to other countries that the US economy is still in poor shape, requiring artificially cheap loans to keep investment growing.

This is partly why raising rates is a balancing act. Move too quickly, before signs of a strong recovery, and business spending might collapse. Keep rates low for too long, and you may blunt the Fed’s main crisis tool, while signaling (unnecessarily) to other markets you’re still weak.

It’s also why in more recent times, the Fed has adopted forward guidance: patiently and frequently signposting future policy changes to come. Let the public know a rate hike is forthcoming, and it’s unlikely, on the day, markets will flutter.

This time is different—sure, markets have a good sense of what’s to come. Based on the FOMC’s last meeting, another rate hike is forthcoming. But a new, and arguably less experienced, person is taking over the Fed. Powell has a track record of keeping with Yellen’s policies, but it’s not entirely clear, without her presence on the board, that he’ll stick to them.

Correction: A previous version of this post said the Fed has raised rates twice since 2015. It has hiked them four times since then.