Fed will and should raise rates

If you have any money surfing the ebbs and flows of Wall Street, you’re probably a little nervous about what the Federal Reserve (Fed) is going to decide at Thursday’s FOMC meeting.  Like most of us, you might not understand the reason why a minute adjustment to the Fed’s discount rate has such wide implications for the economy (or even what a “discount rate” is), but you know it does.  Although it might temporarily mean a hit to our portfolios, the Fed should raise interest rates – and soon – and we’ll all be better off when they do.

The Fed was created to be an independent entity, with a mission to manage the country’s money so that we have the most beneficial combination of inflation and employment.  Contrarily, some think that the Fed’s current intra-office debate will hinge on how much it will impact stock prices, but it really has no reason to take these equity market ramifications into consideration.  Its biggest concern is whether our nation’s economy approaching full employment is going to set off a spate of inflation that we haven’t seen in quite some time (when people have more money, they might spend more, which will drive up prices and devalue our greenback). 


Our portfolio managers, and our representatives in Congress, have reason to be wary, for the economy has been headed – albeit pretty slowly – in the right direction for some time, meaning the Fed is likely to raise rates in the near term, the value of our investments are going to bounce around like pre-primary presidential poll numbers, and Congress will be even more tempted to get involved.

Besides employment gains, why should the Fed raise its rate?  Some have blamed recent extreme market volatility seen in last couple of weeks on the Fed’s long held easy money policies.  They are partly right.  When the Fed uses one of its few monetary policy tools to maintain its lending rate at near zero percent, as it has for a record eighty months, savers and investors find it more profitable to put money in equities than they do to keep it in a savings account that pays negative real interest rates (including inflation).  Risk adverse investors moving money to equities leads to a lot of skittish, and sometimes irrational, major swings in the market like those that occurred in the last couple of weeks.  At the first sign of trouble (e.g. basically anything that happens in China) we head for the hills.  Volatility is part of the reason why a hike is necessary now. 

Another reason is the far more lucid fear of future inflation.  Sure, many hawkish Fed pundits and conservative politicos have been threatening inflation since the Fed began its first round of pumping after the financial crisis, but the anchor has been a poor economy.  Our banking system has a record amount of money held in reserves that finds it more amenable to the deposit interest rate offered by the Fed than the potential returns in business or personal loan lending.  With a good economy comes a greater incentive for this to change, which will mean more money chasing goods and services and driving inflation.

As our economy gets betters, arguments for action that pre-empts inflation become more palatable.  In the next week, the Fed will have to make the tough choice to get out in front of it in some way or another over the next few months, a choice that is sure to reignite Congressional interest in overseeing what the mysterious Fed is doing.

Although Sen. Rand PaulRandal (Rand) Howard PaulConservatives left frustrated as Congress passes big spending bills Senate approves 4B spending bill Some employees' personal data revealed in State Department email breach: report MORE’s (R-Ky.) “Audit the Fed” campaign might again gain some footing when we are reminded that we have but summaries of the Fed’s rationale to consult, the real debate Congress should resume is whether the Fed might be better suited to follow a strict set of public rules.  Doing so will allow market analysts and amateur investors alike to more precisely predict when monetary policies will shift, and will help to stymie short term market volatility.  Research has suggested that the Fed may have applied its own set of self-imposed rules some time ago, but without legal binding and the public’s knowledge, rules serve as but a guide to the Fed’s internal operations.  The Fed may be composed of some of the smartest technocrats our country can find, but discretion in the face of fiscal crisis is a temptation no one in D.C. seems to be able to overcome and can be a dangerous authority for those working in a field of economics that is hotly debated. 

Considering the Fed’s recent temperament, it seems unlikely that it will raise rates this week, but highly likely that it will make a firm promise to hike in the near future, preparing Wall Street as much as it can for the inevitable.  If the Fed’s going to act, it should yank the Band-Aid now.  It won’t be able to avoid the concern of D.C. legislators, or a short-term increase in stock market volatility, but it will provide greater economic stability and confidence in the long-run.

Vélez-Hagan is an economic policy researcher at the University of Maryland-Baltimore County.  He is also the author of the new book The Common Sense behind Basic Economics (Lexington Books).