Fed Should Increase Interest Rates Now

Despite the continued pessimism of some analysts and politicians, America's economic recovery (search) is now firmly established.

The Bush administration's tax cuts and the Federal Reserves "easy money"-low interest rate policy have both worked to increase domestic output and employment. Improving incentives to work and invest while at the same time providing the financial capital to accomplish new production almost always leads to higher levels of economic activity. It's as close to a slam-dunk as there is in economics.

With the recovery well along, however, it's time to reevaluate the administration's economic policy. In my view, Bush's tax cut policy (search) should be made a permanent part of the economic landscape. Reducing taxes is always a good idea; it puts more money in the hands of consumers and private investors. Indeed, income tax rates should be reduced even further and the federal government should be forced by formal spending caps to live within the revenues that lower tax rates provide. On the other hand, the Howard Dean proposal to rescind "every dime" of the recent tax cuts is bad politics and even worse economics.

Federal Reserve (search) policy is another matter entirely. Economists generally maintain that interest rates (search) must decrease and the Fed must provide additional liquidity when the economy is in recession. Fine, the Fed has done just that. The recession officially ended more than 20 months ago, and today the overall economy is remarkably robust. Clearly, monetary stimulus is no longer necessary; indeed, if continued, it is likely to be harmful.

Real interest rates (interest rates adjusted for inflation) are at a 30-year low and the real federal funds rate (the bank-to-bank interest rate) is nearly negative. This is now spectacularly incorrect monetary policy given the current economic reality. To see why this is so it must be understood that the Fed creates low interest rates by purchasing government securities from financial institutions ("open market operations"), the effect of which is to increase liquidity (credit) throughout the financial system. The "new" money created by the Fed is then lent out or invested by these financial institutions and finds its way into the economy.

As an example, in Southeastern Florida the effects of the Fed's excess liquidity are all around us in the form of a housing "boom." Easy credit allows developers to purchase and clear land and allows builders (and their customers) to borrow and build, borrow and build. Now some home building is, of course, appropriate, but the recent vast expansion in residential housing (and the increase in prices) mostly has been fueled by "easy money" from the Federal Reserve. Absent the Fed expansion, homebuilders and developers would only be able to borrow what others had saved in savings, and interest rates would be far higher. It is time for the Fed to wean the economy back to levels of economic investment that are sustainable without Federal Reserve credit.

Higher rates will serve two purposes. First, as already argued, they will slow the pace of investment in areas where investment has been too rapid and where inflationary problems are already apparent. Second, they will increase private savings by providing increased incentives to save. Home building will not "collapse" as the Fed withdraws liquidity; higher interest rates will encourage private savers to increase their savings, which will then fund an appropriate and sustainable amount of new investment. Further, since rates on CD's and other fixed income assets will increase, savers will be rewarded with high incomes, which they can spend or invest.

Unfortunately, the Federal Reserve has pledged publicly to maintain low rates (that is, easy money) into the foreseeable future (or at least until the next national election). Bad idea. The real estate price bubble and the weakening dollar against gold and the Euro are signaling that real interest rates must increase. By continuing its anti-recession monetary policy into the recovery phase of the business cycle, the Fed risks sowing the seeds of the next business cycle downturn.

Dom Armentano is an adjunct scholar of the Cato Institute. He lives in Vero Beach, Florida.