Tuesday, March 2, 2010

The Case For (and Against) Raising Interest Rates

One of the Federal Reserve Bank's most powerful tools is raising short term interest rates.  Why they should (and why they shouldn't) do just that now.
Short Term Interest Rates
Didn't the Fed just raise rates?  Yes, they raised the Discount Rate by 50 basis points (1/2%).  The Discount Rate is the rate that the local branch of the Federal Reserve Bank charges for short term loans.  There are three types of loans available from the "Discount Window."
There is also the Fed Funds Rate, which is the rate banks lend money to each other at the local branch of the Federal Reserve Bank, in order to meet the reserve requirements they must set aside for liquidity purposes.  This rate, currently .25%, was set on December 16, 2008, during the recent financial crisis.
Extraordinary Measures
The Federal Reserve undertook several extraordinary measures to assist financial institutions during the recent the financial crisis. Besides providing loans to banks through the discount window lending programs referenced above, the Fed established other ways to provide liquidity to financial institutions, including:
In short, the Fed became "the lender of last resort," after effectively lowering the Fed Funds rate to zero.
Now, by most measures, the liquidity crisis has been averted, and many of the programs listed above have been suspended.  Some economists feel that it is now time for the Fed to raise the Fed Funds rate and unwind other extraordinary credit facilities, and some feel that it should wait.  Here are the pros and cons.
Raise Rates Now
Those in favor of raising rates now generally feel that by raising rates gradually, the economy will avoid creating future excesses like inflation caused by holding rates artificially low.  This position represents the free market philosophy that the economy must move through the process of recovery without intervention by the Fed. 
Such economists see the 3% - 3.5% projected US growth in Gross Domestic Production this year partially due to previously provided economic stimulus, but more importantly through sustainable growth in global demand.  Acknowledging the problem of high unemployment rates, they think that potential problems created by guaranteeing low rates for the foreseeable future will create more serious economic excesses in rate sensitive sectors in the future.  In effect, this policy is seen as "postponing the inevitable," and proponents of this philosophy favor no economic intervention unless absolutely necessary.
Keep Rates Low
Those in favor of keeping short term rates near zero generally agree with the 3% - 3.5% projected US growth in Gross Domestic Production this year, but feel that reliance on growth in global demand is more precarious.  Citing recent concerns with the sustainability of the current recovery, including high rates of US unemployment  and sovereign debt risk abroad, proponents of this philosophy feel that Fed intervention will lessen the risk of slipping back into recession, and see that risk as more probable than creating inflation by keeping rates artificially low.
Weighing the Probabilities
Those who participate in this discussion often do so by labeling their opinion as "capitalist" or "progressive."  To do so is to grossly oversimplify the issue.  Whether rates should be raised or not lies simply in the measurement of future global demand.  Should demand be sufficient to sustain US growth, then interest rates should be raised, and the growth in production will result in new hiring that will eventually lower unemployment.  The amount of projected global growth in 2010 depends upon whose data you rely.
The World Bank projects 2.7% growth this year, slightly more pessimistic than the International Monetary Fund's projection of 3%.  The two organizations use different methods in calculating GDP, which partly accounts for the disparity.
For comparison purposes, global GDP growth was 5% in 2004, 4.5% in 2005, 5.1% in 2006, 5.2% in 2007, 3% in 2008, and -1.1% in 2009. 
Those in favor of raising interest rates feel that relying on growth from global demand projections in an admittedly sub-par year present less risk than the potential inflationary excesses that may be caused by keeping rates low.
Those in favor of keeping rates low feel that the probability of damaging a fragile recovery by raising rates are higher than causing future inflation by not doing so.
Clearly, choosing the wrong course of action may result in significant economic problems. 
What is your opinion, and why?

No comments:

Post a Comment