Should the Fed Raise Rates?

I read an interesting article last night on Bloomberg suggesting that Bernanke should consider raising interest rates from its current historic lows. Traditional methods of monetary policy implemented during this recession have failed to lead the United States out of recession. Growth continues to stumble, questions about a double-dip linger, unemployment hovers around 10-percent, and the housing market lacks a foundation. So what argument can be made for raising rates, a tactic normally employed to slow down the supply of money?

When the Fed dropped rates to record lows near zero per cent, it was hoped that the banks would increase loans to small businesses and home buyers, but tightening credit policies and risk management strategies by the banks prevented these loans to enter the economy. Instead, financial institutions used their "free" money to invest in themselves through trading and building other assets. The government has unintentionally rewarded the banks for their bad behaviour and is creating another potential crisis.

"Blow the system up, we'll come back and reward you with very low interest rates that allow you to build up capital, and then you could try it again next time around," Rajan said.

Concerns about inflation, a usual suspect during times of low-interest rates, were valid, but with low consumer demand, prices of goods still remain low in America, even as commodity prices, like wheat, base metals, and soybean rise from Chinese demand. The Fed's current stance of deflation (when prices fall for extended periods of time) prevention is currently the number one issue blocking a rise in interest rates.

Rajan also points out that low interest rates are artificially "propping up" the housing market in America by creating demand from speculators. Americans continue to carry large amounts of household debt, near record levels in fact - $11.7 trillion as of June (according to the article). With debt levels so high and banks managing credit worthiness more conservatively, those looking to get loans may be out of luck. Foreign speculators in the housing market is historically high, a possible link to Rajan's argument.

If the government does not want to raise rates to prevent deflation, the government should cut out the middle man, the banks, and go directly to the American citizen. Instead of providing loans to the banks and being at the mercy of new credit policies, provide loans directly to the small businesses that want to expand and to the credit-worthy American who is unable to obtain a loan. Some stimulus plans proved effective long-term too.

The Cash for Clunkers program, which ended months ago, re-ignited the auto industry. Providing temporary jobs to Americans via the census earned the economy a respectful quarter of growth.

Although these programs will cost tax payers billions, the government's current policy of low rates has created a cheap way to sell treasuries and notes, and why not take advantage of super-conservative investors willing to take just 2.5 to 3 per cent yields on a 10-year?

With Christmas just one quarter away, the government could also provide incentives for companies that hire immediately after summer ends when students head back to class. I'm certain many companies would go along with it in hopes that it spurs the economy and ultimately, their top and bottom line too. Companies are hording trillions of dollars in cash, since risk-free assets are paying so little, so CEO's may be more willing to spend if the right tax benefit or other incentives proves beneficial.

I remember saying the day of his inauguration, if Obama and his administration can get the US out of its deep recession, he would be considered one of the greatest presidents ever.

The Fed must think outside of the box, outside of traditional monetary policies to stimulate this economy. Banks are building up assets for free and creating a potential bubble, again, but this time without strengthening the economy. Raise rates and force banks to make money on interest again by expanding loans to Americans. If banks fail to lend, governments should directly lend to citizens, which would create new jobs and provide a second source of income other than tax, which could be used to pay off debt. Allow the housing market to finally collapse, providing very affordable homes for Americans with newly approved loans and hopefully improve the flow of money.