Weekly

1. Page 1 of 2
Economic Commentary
QNB Economics
economics@qnb.com
28 June, 2015
Should the Fed Raise Interest Rates in 2015?
We are getting ever closer to the first interest
rate increase by the US Federal Reserve (Fed)
after years of near-zero rates. Following the
Fed’s meeting on June 17, markets are almost
evenly split on the date of the lift-off between
September and December 2015. But there is
still considerable disagreement on whether the
Fed should be raising rates in the first place.
Some argue that with inflation running well
below the Fed’s 2% target (the Fed’s preferred
measure of core inflation was 1.2% in April),
the Fed should at least keep interest rates at
their current low levels. Others disagree with
this argument and point out that the
unemployment rate of 5.5% is close to the 5.0-
5.2% estimate of the equilibrium rate of
unemployment. The Fed, the argument goes,
should therefore be raising interest rates soon
to prevent the economy from overheating.
Who is right in this debate?
One way to answer this is to use the Taylor
Rule, named after John Taylor of Stanford
University, who first introduced it in 1993. The
Taylor Rule is an equation that prescribes the
central bank interest rate based on the amount
that inflation and unemployment are
deviating from their targets. As the chart
shows, the Taylor Rule provides a good
description of the Fed’s policy rate in the years
before the 2008 financial crisis. The chart also
highlights the Fed’s dilemma since the crisis,
when the rule was recommending deeply
negative levels of interest rates. The Fed could
not set interest rates below zero, and resorted
instead to unconventional monetary
instruments like quantitative easing.
So what is the Taylor Rule recommending
now? With inflation at 1.2% and
unemployment at 5.5%, the Taylor Rule,
which combines both inflation and
unemployment to come up with the optimal
interest rate, recommends that the Fed’s
policy rate should be at 0.36% as shown by the
red line in the chart. This is close but slightly
higher than the Fed’s current policy range of
0.0-0.25%. If we use the Fed’s projections for
where unemployment (5.25%) and inflation
(1.35%) will be by end-2015, the Taylor Rule
recommends that the interest rate should rise
to 0.78% by year-end. This is around 0.5%
above current policy rate, which is equivalent
to two rate hikes. The prediction is in line with
the Fed’s forecast that there will be two rate
hikes this year.
Federal Funds Rate vs. The Taylor Rule
(%)
Sources: Bureau of Economic Analysis, Bureau of Labor
Statistics, The Fed, and QNB Economics analysis
The Taylor Rule, therefore, is in favour of
raising interest rates this year, given the Fed’s
baseline forecasts for inflation and
unemployment. There are however risks to
this view. First, there is considerable
uncertainty about the economy and whether
the Fed’s forecasts for unemployment and
inflation will be realised. This is especially
relevant in light of the weak performance in
the first quarter of the year, in which real GDP
shrank by 0.2%. Second, raising rates could
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0.0
2.0
4.0
6.0
8.0
10.0
1990 1995 2000 2005 2010 2015
Federal Funds Rate Taylor Rule

2. Page 2 of 2
Economic Commentary
QNB Economics
economics@qnb.com
28 June, 2015
spark sharp corrections in the equity and bond
markets, which could then have a negative
impact on the real economy. Third, raising
rates could trigger capital outflows from
emerging markets, which could in turn
adversely affect the US through a stronger
dollar and lower net exports.
These are all legitimate concerns, but most
will probably apply to any time the Fed seeks
to raise interest rates. Furthermore, whether a
mere 25 basis points hike happens two months
early or late is not that important in isolation.
What is more important is the speed of
subsequent rate hikes, as this could make the
difference between a rate of 1.0% or 3.0% at
end-2016 for example. The Fed can easily
adjust the speed of rate hikes after the lift-off.
It could even reverse some of the tightening if
it feels it was premature. For now, however,
the Fed seems intent on raising interest rates
in the coming months. Taylor agrees.
Contacts
Rory Fyfe
Senior Economist
+974-4453-4643
Ehsan Khoman
Economist
+974-4453-4423
Hamda Al-Thani
Economist
+974-4453-4646
Ziad Daoud
Economist
+974-4453-4642
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