© 2024 St. Louis Public Radio
Play Live Radio
Next Up:
0:00
0:00
0:00 0:00
Available On Air Stations

Commentary: The upside of rising interest rates

This article first appeared in the St. Louis Beacon, June 25, 2013: Looking at stock prices over the past few months, May 22 stands out. That was the first time Fed Chairman Ben Bernanke “rocked” the markets with his comment that maybe the Fed would reconsider the magnitude and duration of its current buying scheme.

His comments following last week’s meeting of the Federal Open Market Committee were seen as another blast of bad news for stocks. Under certain conditions, Bernanke said, the Fed would scale back its current program. And the market roiled in a predictable manner, losing several percentage points of value by week’s end.

Maybe that’s a good thing.

The Fed has engaged for the past couple of years in a policy aimed less at lowering rates, and thus spurring economic activity, and more of keeping rates low and keeping the financial markets content. The Fed has been unable to lower rates because its policy lever, the Federal funds rate, is already effectively at zero. Holding the Fed funds rate at such a low level was intended to keep the economy from plunging further into recession.

Unfortunately, the economy did not respond as predicted by textbook models and experience. Economic growth has remained morbidly slow and unable to create enough jobs to bring the unemployment rate down.

The Fed became more aggressive when it instituted quantitative easing, a policy that allows it to purchase a wide range of financial securities, such as mortgage-backed securities, from banks and other financial institutions. This policy has kept interest rates at all-time lows, and banks flush with reserves. In its most recent incarnation, the Fed buys about $80 billion in securities each month until the economy (read: the unemployment rate) rebounds sufficiently.

Everyone knows that the Fed must eventually curtail its purchases. The so-called taper — the reduction of these monthly purchases — would result in an increase in interest rates. So why did Bernanke’s comments roil the stock market and pique some commentators?

Because financial markets hate uncertainty. Even though dealing with risk and uncertainty is exactly what such markets are supposed to do, an uncertain future means that some investors will win and some will lose. And being a loser means lower profits for some traders and financial institutions. That puts enormous pressure on the Fed to fix rates at some level, even if economic common sense, not to mention sophisticated economic models, suggest doing otherwise.

What’s wrong with fixing rates at near zero for the foreseeable future? Markets are no longer setting rates, the Fed is. With an inflation rate of about 2 to 3 percent, history suggests that market rates should be in the range of 4 to 5 percent. A near-zero rate is not what markets would produce without the Fed’s interference.

If interest rates climb to 4 percent, won’t that terminate any recovery we’ve had to date? This is Paul Krugman’s view, one also held by others who believe that the government should spend whatever it takes to lower the unemployment rate. But what would happen if rates rose to more traditional levels?

For one, banks would start to lend more. That would help create the jobs that everyone so desperately wants. Incomes would increase, and the economic recovery would more closely align with historical norms.

Ending its stimulus scheme would give the Fed a needed opportunity to manage the drawdown of the surfeit of bank reserves its actions have created. Banks hold these reserves against deposits. Any extra amount — called excess reserves — represent funds just waiting to be loaned. The Fed has pushed the amount of excess reserves in the banks from an average of less than $2 billion before 2008 to a recent value of almost $2 trillion. This buildup of reserves is why some economists fear that inflation could rise in the future unless the Fed gets control of the situation.

Although traders often forget this, the Fed’s job is not to make them richer by fixing rates at some low value. Other objectives take precedence, such as maintaining a stable economy and, even more important, keeping inflation low over time.

Everyone wanted more transparent policy and now they complain when they get it. Chairman Bernanke should be praised for his forthright discussion of the policy options he and the FOMC face. To paraphrase Mick Jagger, you can’t always get what you want, but sometimes you get what you need.

R.W. Hafer is a distinguished research professor of economics and finance at Southern Illinois University Edwardsville and a research scholar with the Show-Me Institute, St. Louis.

Rik Hafer is a distinguished research professor in the Department of Economics and Finance at Southern Illinois University Edwardsville and a scholar at the Show-Me Institute.