Fed's Credibility at Stake

Federal Reserve policymakers meet Tuesday and Wednesday to discuss when to raise interest rates and how they will communicate those intentions without upsetting financial markets or the economic recovery. Unfortunately, the Fed is constrained by its own past missteps, and its credibility is at stake.

Short term rates have been near zero since 2008, and along with Quantitative Easing–the Fed’s purchases and continued holdings of long-term bonds–those have held down the whole structure of rates on bonds, mortgages and consumer loans to arbitrarily low levels, and imposed significant distortions on the economy.

Low rates discourage bankers from lending to businesses that create jobs, because they fear being stuck with low yielding assets when the rates they must pay to keep deposits could go up a lot in the future.

Instead cheap money encourages Wall Street speculators and bankers to gamble in foreign exchange and commodities markets, and similar activities of dubious economic value, to continue paying multi-million dollar bonuses. For example to Democratic operatives like Lazard Ltd global banking head and Obama nominee for Under Secretary of Treasury, Antonio Weiss.

In addition, low rates have inflated prices for agricultural land, stocks and junk bonds issued by companies with dodgy prospects, and homes in tonier neighborhoods such as Manhattan and San Francisco.

Seen in these terms, higher interest rates might actually be more beneficial to instigating growth by eliminating perverse incentives and the terrible misuse of capital for speculative, unproductive purposes.

Apparently they don’t teach at Pembroke College, where Fed Chairwoman Yellen attended, what the rest of us learned in Economics 101. Namely, easy money can do little to boost economic growth when the economy has a great deal of slack.

With one of six men between the ages of 25 and 54 without a job, the U.S. economy has more slack than a six foot clothes line hanging on poles two feet apart.

With Wall Street now hooked on low rates, the Fed can’t raise rates abruptly. It must telegraph intentions in advance, to permit big campaign contributors to get their risky portfolios in order.

When the Fed policymaking committee meets, it will once again debate dropping from its policy statement the assurance that it will hold down short rates for a “considerable time,” and replacing it with language indicating it will still be patient about timing. That would reinforce expectations that the Fed will raise rates in June or July.

The problem is that the recession in Europe and slower growth in China and other developing countries could push oil prices down further, and derail the boom in American production and recent acceleration in U.S. growth. And although low interest rates might not be helping growth much, those must be withdrawn when economic prospects are brightening, not growing darker.

Repeatedly, Fed policymakers have been too optimistic in their forecasts and were forced to delay ending its purchases or long-term bonds, and now the same may prove true for raising ultra-low interest rates.

The Fed could try genuine candor. Simply tell markets and Americans that low interest rates have long-ago served their purpose and if the economic expansion continues, it will begin raising interest rates in June.

2015 is the year to get something done, because in 2016 the presidential election will cloud Yellen’s judgment.

During the mid-term elections, she inappropriately sided with Democrats by stating widening income inequality might be inconsistent with American values, when the party known for mule-headed economics was campaigning on issues such as raising the minimum wage.

Unfortunately, that behavior casts a great shadow on Fed policy independence and should be the focus of great attention by a Republican Congress.

Rates need to go up for both economic and political reasons–the sooner the better.

Peter Morici is an economist and professor at the Smith School of Business, University of Maryland, and a national columnist. Follow him on Twitter @pmorici1.