Interest Rates … Time For A Raise?

No. No. No.

Not at all.

One of the oddest discussions now taking place in economic policy making circles is the one that concerns when, and how fast, interest rates should be raised. I find it odd simply because there is no analytical, theoretical, support anywhere for a raise. It is likely to stay that way for many months. So why is it that practically every day I see articles opining on the subject, and read of miscellaneous Federal officials – usually from the more obscure regions of the Federal Reserve System – making tough statements about how it mat be necessary for the fed to raise rates even if unemployment has not improved.

“Tighter money now would not just slow the recovery, it would eliminate it.”

Say what?

Frankly a raise in rates could not be more catastrophic. So what’s with all this talk?

Traders. That’s what.

The only people who could conceivably benefit from higher rates are within the trading community. Everyone else would lose. And lose big.

The whole discussion is simply an aspect of the ongoing war within the economics world about whether a stimulus was a good idea and whether the Fed has gone too far in pumping money into the economy.

I touched on some of this at the end of last week, but let’s review the facts anyway.

The Fed raises and lowers interest rates as its primary management tool as it tries to keep the economy growing at an even rate. The objective is to prevent surges in inflation and to balance the threat of inflation against the threat of unemployment. The recent bias has been to ‘manage’ inflation’ aggressively on the principle that a low and steady inflation rate provides a strong basis for a healthy economy.

There is a rule of thumb called the ‘Taylor Rule’ which provides an analytical background for policy as the Fed goes about this balancing act. Essentially the Taylor Rule – developed by John Taylor, a conservative economist from Stanford, is a regression analysis that provides a good fit with actual Fed policy over the last few decades. The Fed itself doesn’t openly say that it uses the taylor Rule, but it reports on where rates would be if it did. As I just noted for most of the last few years rates have tracked the rule well.

The problem we have now is that, given the gap between actual output and potential output in the economy, and given the very high unemployment we ore now experiencing, the Taylor Rule indicates that the Fed should be holding the Fed Funds rate – its primary weapon in rate management – at -5%. That’s right, minus 5%. Or maybe even closer to minus 6% depending on your view of the unemployment trend.

Since it is not possible to run negative nominal interest rates – imagine what would happen if the bank had to pay you interest when if borrowed from it – the Fed is stuck. It has hit what economists call the ‘zero bound’. So even though all the signs are that we need lower rates to get the economy moving, we cannot go there. This is why the Fed has had to resort to all sorts of unorthodox and never before seen methods to get cash into the economy. The result of these methods – collectively called ‘unconventional easing’ in the jargon of monetary economists – is that the banking system is awash with cash. Cash that is going nowhere because banks are refusing to lend while they are afraid of future loan losses.

This is where the interest rate ‘hawks’ – those who want to lift rates sooner rather than later – enter the discussion.

Generally speaking the hawks are folks who objected to the unconventional easing in the first place. They saw that sea of cash as an inevitable trigger of future inflation, and have lived in terror of it ever since. They are the ones using emotive phrases such as the ‘upcoming great inflation’ and urging a quick reversal of the easy money strategy currently dominating Fed policy. They are also the kind of analysts who see inflation as the only object of Fed policy – they argue that the Fed has no impact on unemployment except as a derivative of its primary function as regulator of tight money. Therefore targeting an unemployment rate, or even worrying too much about it, is irrelevant to the formation of sound Fed policy.

Needless to say most of these people are conservative politically and very oriented towards money market matters.

They are also nuts.

There is nothing in any theoretical tract that I am aware of that would argue for higher interest rates any time soon. Nothing. On the contrary, using that Taylor Rule and plugging in forecast activity in the economy, it seems that we should be continuing our current easy money policy regime until the unemployment rate has fallen to somewhere around 7% to 7.25%. No one that I know of thinks we will reach that happy point for a few quarters. Most think we won’t arrive at that level of unemployment until 2011 at the earliest. Raising rates before then would be seriously, and possibly fatally, damaging to the recovery.

It is not as if we have no history to guide us. The Fed made exactly this mistake in the late 1930’s. It raise rates too soon and choked off what appeared to be a healthy recovery sending the economy lurching straight back into depression. A depression that only the wartime build up of the early 1940’s ended.

So why are the hawks so aggressive in trying to force rates up?

Because they are money market people and are fearful of the reaction of the bond market to continued easy money as the recovery begins to take hold. The bond market is very sensitive to inflation, it builds inflation ‘expectations’ into its interest rate requirements. This is very rational behavior. After all a bond can have a very long life – up to 30 years – so an investor is exposed, theoretically, to a variety of risks not least of which is having the value of their investment depreciated by high and prolonged inflation. Conversely, a borrower such as the US government is quite happy to see high inflation since the money that they eventually have to pay back will be expressed in currency considerably diminished in value by that inflation.

It is because the hawks and the bond markets are suspicious that the government would like to encourage a higher rate of inflation – so as to reduce the impact of the deficit on future generations – that they want to see the breaks slammed on early. Inflicting a little bit of good old Puritanical pain on the unemployed is of no consequence to the hawks as long as the dollar remains strong. Maintaining that strength, for them, is paramount, and can only be accomplished by running rate up as soon as the recovery begins. That means raising rates early next year at the latest.

So that is the debate. Those in favor of an early rate hike have no theory to support them, they simply are biased towards a tight money policy so as to maintain bond values. They see all that cash sloshing around on bank balance sheets as the most dangerous aspect of the current economic situation. they want those bank reserves drained as soon as possible. Even if that slows the recovery.

They apparently forget the 1930’s lesson.

Tighter money now would not just slow the recovery, it would eliminate it.

Nothing could be worse.

Having a bond market bias is not necessarily a good credential for a central banker. In fact it is, currently at least, the acme of a disqualification criterion.

However, there seems to be a ton of those hawks about so I expect this discussion to run on through the winter. Which is too bad, since it distracts us from managing our way through the transition from our current stimulus supported recovery towards a self sustained one.

A sustainable recovery with more jobs should be our goal. Frankly a little inflation, to help ease debt burdens, would help us get there. No wonder the bond market is getting antsy.

Meanwhile: let’s vote no on any rate increases.