Tags: federal reserve | economy | rates | janet yellen

Fed Should Raise Rates Now So It Can Cut Them Later

Fed Should Raise Rates Now So It Can Cut Them Later
(Dollar Photo Club)

By Wednesday, 16 September 2015 10:56 AM Current | Bio | Archive

The Federal Reserve honchos might announce a rate hike tomorrow, or they might not.

They could be rolling dice in there for all we know. Will it matter either way?

Yes, it will matter, but not for the reasons you might think.

Fed officials from Janet Yellen on down say their decision will be “data-dependent.”

This tells us nothing. You or I can look at the same economic data the Fed does and reach very different conclusions.

We see what we want to see. So does the Fed.

This being the case, nothing they do should surprise us. What I hope they will do is start raising short-term rates gradually up to the 2% area.

I don’t hope this because I think the economy is starting to overheat. Everything I see tells me it is still struggling.

I have a different reason, one I first heard from my colleague John Mauldin at Mauldin Economics. He thinks the Fed should raise interest rates now because it is possible — perhaps likely — we will have some kind of financial crisis in the next few years, and the Fed will need to create liquidity.

As it stands now, the Fed has no good options. The federal-funds rate is already effectively at zero. Unless they want to push interest rates below zero, additional quantitative easing will be their only weapon.

QE is a monetary blunt instrument. Imagine trying to pull a screw from the wall using only a hammer. You can get it out, eventually, but you’ll cause some damage, too.

Another reason not to depend on QE is that it can’t work forever. Under QE, the Federal Reserve buys assets in the public market. The last three rounds involved buying Treasury bonds and mortgage bonds, but it could be anything. The Fed adds the assets to its balance sheet and gives the sellers cash, which then trickles through the economy. That’s the theory.

The problem is that at some point there are no more assets to buy. The supply of bonds available for purchase has a limit. The Bank of Japan is already running into this problem with its own QE program.

Last week, the International Monetary Fund released a research report analyzing the BOJ’s impact on the Japanese bond market. The authors believe BOJ will start hitting the wall as early as 2017 — 15 months from now.

Now, the Japanese QE program is far larger, relative to the size of its economy, than what the Fed has done here. Remember, though, that while our QE program is no longer growing, it isn’t shrinking, either.

The Fed is still rolling over the bonds on its balance sheet as they mature.

So, if some other catastrophe should occur in, say, 2016, what could the Fed do?

If cutting interest rates is off the table, it will have to launch another QE program on top of the previous rounds it hasn’t yet reversed.

The Fed’s balance sheet could easily reach Japan-like proportions quickly in that scenario.

But this can only happen if the market has enough liquid bonds the Fed can purchase.

Those bonds may not exist.

What happens then is anyone’s guess. We can safely say it won’t be good.

Will such a crisis occur? I have no clue. Maybe I’m jumping at shadows.

Yet with the “Too Big to Fail” banks far bigger now than they were in 2008, we could be in deep trouble if some shocking event unfolds.

Now, I still think it would be long-term preferable to have the Fed butt out and let the banks fail. As Keynes supposedly said, in the long run we are all dead. Reaching free market nirvana will bring a lot of short-term pain. I would rather find a smoother path to get there.

So, the least-bad option is for the Fed to raise rates now so it can cut them later, if necessary. Going from 0% to 2% will not kill the economy, especially if they do it gradually.

Is Janet Yellen thinking this way? I sure hope so. We may all regret it if she is not.

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PatrickWatson
The least-bad option is for the Fed to raise rates now so it can cut them later, if necessary. Going from 0% to 2% will not kill the economy, especially if they do it gradually.
federal reserve, economy, rates, janet yellen
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2015-56-16
Wednesday, 16 September 2015 10:56 AM
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