Janet Yellen has gone out of her way to reassure financial markets that the Fed will raise interest rates very slowly, but she would do well to lay out a schedule for rate increases. This would promote confidence in Washington’s ability to manage the economy and raise the interest rates ordinary folks can receive on their savings accounts and government bonds.
After keeping the federal funds rate—the overnight rate banks pay each other for loans—near zero for seven years, the Fed raised its target a quarter point in December. Now the consensus of Fed policymakers is that the rate will be increased another quarter point at the conclusion of only two of their six remaining meetings this year.
Despite the recent recovery in stock prices, investors remain jittery, because foreign economies remain weak, and central banks in Europe, Asia and elsewhere are running out of bullets to combat deflation. Also, equity investors, who see low interest rates as favorable to stock prices, keep hoping the Fed will put off even those two rate increases.
However, delaying further adjusting interest rates risks igniting inflation the Fed would be hard pressed to contain. Consumer prices less energy are now rising more than the Fed’s target of two percent a year for overall inflation. With gasoline prices rising again, overall inflation will exceed that target in the months ahead, and the Fed needs to act now before things get out of hand.
With the U.S. economy now on a more resilient path than many feared, the Fed should take this opportunity to raise rates so that when things turn sour again it has some ammunition—namely the ability to lower interest rates.
Currently, in the event of an economic downdraft, the Fed is faced with pushing short-term interest rates into negative territory but that has not worked well abroad.
The Bank of Japan, European Central Banks and their brethren in Sweden, Switzerland and elsewhere are charging commercial banks interest on their deposits at central banks. In turn, the banks are charging large depositors—mostly businesses—for the privilege of keeping their money in bank accounts.
To avoid paying interest, businesses are paying taxes early or simply hoarding cash—surprising amounts of currency can be kept in company vaults. Keeping with this trend, the Bavarian Banking Association has recommended that its members stash extra cash in vaults rather than on deposit at the ECB.
Paying taxes early and hoarding cash is the opposite of what negative interest rates were supposed to encourage—more spending and lending.
Similarly, when banks pay borrowers to take cash, or at least lend on very generous terms, credit gets used for the worst purposes—to prop up balance sheets of doomed companies or speculation that creates asset bubbles.
Amid the uncertainty, the yen and euro have actually risen in value in recent months as central banks have broadened their purchases of securities to private companies. And choosing which businesses to support takes central banks into the murky world of industrial policy—picking winners and losers—and makes them vulnerable to even greater political pressure than they usually endure.
The Fed policymaking committee meets every six weeks, and as each meeting approaches pressure on Yellen mounts from financial markets to indicate she will put off a rate move until the following meeting—as she did last week in a speech in New York for the upcoming April 26-27 meeting.
It might be better for the Fed to announce it will raise interest rates a modest one-eighth or one-sixteenth of a point at each meeting going forward. A gradual one-half to one percentage point a year would hardly be enough to roil Treasury or equity markets, cause a sudden jolt in mortgage rates and home building, or disrupt business investment plans.
A schedule of increases would give certainty to markets and establish confidence by economic actors, generally, that the Fed has the resolve to restore interest rates to a reasonable level.
Peter Morici served as Chief Economist at the U.S. International Trade Commission from 1993 to 1995. He is an economist and professor at the Smith School of Business, University of Maryland, and a widely published columnist. He is the five time winner of the MarketWatch best forecaster award. Follow him on Twitter @PMorici1.