Story Highlights:
- Disagreement on the federal interest rate centers on inflation and unemployment.
- The Fed vowed to keep the rate very low for “an extended period” this week.
- Gradual tightening should occur as soon as the unemployment number drops.
Survey a random sample of the world’s leading economists about the state of United States economic recovery and you’re likely to receive the gamut of responses. Recovery has been a highly debated topic since the Dow Jones Industrial Average began creeping up some months ago. Ultimately, each economist, trader, investor, or corporate CEO bases his or her own decisions upon subjective interpretations. Ben Berananke and The Federal Reserve, however, must take a crucial stance on the state of the economy, as federal interest rates affect all sectors of the U.S. financial system.
This past week, reports out of the Fed stated that the “weak” economy could not yet handle a rise in interest rate, which is currently hovering around zero. Clearly, the evaluation at hand is utilizing a distinction between economic activity on Wall Street and that of the general public. The most heavily weighted factors continue to be the unemployment rate and inflation (outlined in the reports released Wednesday), reflected by the fact that the Fed called the economy “weak” despite a 3.5 percent growth in the third quarter.
A low interest rate accomplishes several things. Ultimately, it stabilizes the economy by limiting the amount one bank can charge for lending to another. This stimulates lending and borrowing, all the while reducing the burden on those who owe money. In a time of high default and low reserves, such interest rate levels are essential to recovery.
The question can be raised about how keeping interest rates near zero will affect the long-term recovery of the U.S. economy. By announcing that rates will remain low, Bernanke and the Fed are avoiding market shock—that is, allowing banks, lenders, traders, etc. to prepare and make decisions with the knowledge that rates will be low for “an extended period.” Without a doubt, this restores economic activity in the short term and helps to unclog the credit markets. However, inflation is the main concern in keeping rates low.
Federal interest rates are a built-in protection against rapid inflation. When rates are high, money supply is restricted and therefore limits inflationary processes. However, such low rates can promote lending and transaction so much that inflation can accelerate. The Fed is banking on the fact that high unemployment numbers keep inflation in check as well. What Bernanke calls “substantial resource slack” is the preferred method of restricting inflation. By having unused capital—labor and production processes—money supply is also kept low.
I believe a tightened monetary policy is needed in coming months. While the short-term recovery was certainly the correct move, a resurgence in the economy necessitates a gradual reduction in federal aid. While pulling out too quick can deliver results much like those of early-Depression consequences, excessive stimulation can weaken the long-term recovery of the nation. Low interest rates discourage savings and conservative lending practices—two of the factors that put the nation in this position in the first place.
As for the moment, simple calculations would urge the Fed to keep rates low. The Taylor rule (where, simplified, the target rate = 2 + 1.5 * inflation - 2 * the surplus level of unemployment) gives us a figure of somewhere in the -5 to -6% interest rate—zero being the logical figure to use. However, as soon as unemployment declines to a number that brings this Taylor rule-figure to zero, tightening should gradually occur. While it may seem absurd to say that the Fed should tighten while unemployment numbers are still relatively high, it will be better to endure the slight difficulties in favor of a more prosperous future.
