Imagine you have a serious illness and have been taking medication that was supposed to cure you long ago. After being on the maximum dosage for years you start to feel better, so you ask your doctor if you could roll back the dosage, ever so slightly, to alleviate some of the side effects. He says that would be fine—but then a pharmaceutical rep tells you that doing so would be dangerous. Whose advice would you follow?
This resembles the situation today as the Federal Reserve signals its intent to start raising interest rates, ever so slightly, after six years of near-zero rates. This extraordinarily loose monetary policy was introduced in late 2008 when the global economy was in free fall. U.S. gross domestic product was plunging, the unemployment rate was rising and would soon climb above 10%, and in March 2009 the Dow Jones Industrial Average would fall below 7000.
Although at the time few could argue with the need for such extraordinary Fed action, the U.S. economy today has been growing for several quarters. Unemployment is below 6%, and the Dow recently reached an all-time high above 18000. An outside observer might think that taking some modest steps back toward a normal monetary policy is a no-brainer. Not so. Within and outside the Fed there is a great debate as to when, and sometimes whether, the Fed should start raising rates, even by a trivial amount.
Charles Evans, president of the Chicago Fed and a voting member of the board that determines rate policy, said last month that raising rates too soon would be a “catastrophe.” Former CEO of General Electric Jack Welch , during a Feb. 4 interview on CNBC, called a possible spring rate hike “ludicrous.” Billionaire investor Warren Buffett told Fox Business Network on the same day that he didn’t think a rate increase this year would be “feasible.” Catastrophe. Ludicrous. Not feasible. Really?
It might help to put this into historical perspective. According to the Fed’s own monthly data, for the five decades (1954-2007) leading to the current rate-cut cycle, the benchmark, overnight federal-funds rate averaged 5.7%. In the 1980s the rate went as high as 19% and in the early 2000s, after the dot-com crash, it went as low as 1%. But the 5.7% average is the number that withstood the Vietnam War, the Cold War, the stagflation of the 1970s and the boom of the 1990s. Since December 2008 the fed-funds rate has been kept close to zero.
The Fed’s proposed increase would take the fed-funds rate from near zero to about 0.25%, and no that isn’t a misplaced decimal point. We aren’t talking 2.5%, which would still be less than half the 1954-2007 average. We are talking 0.25%, which would mean the Fed’s monetary policy would be rolled back from full pedal-to-the-metal to a fraction above pedal-to-the-metal. On a historical chart of the fed-funds rate, the proposed hike would barely be visible to the naked eye. Does that sound like inviting catastrophe?
The adage about academic politics—that they’re so intense because the stakes are so low—can now be extended to the current wrangling over monetary policy. After all, if the Fed’s stimulus program had been a great success, or at least had come close to its own original growth forecasts, there would be no debate today. The economy would be booming, and maintaining maximum monetary stimulus would be viewed as dangerous. The only debate left would be when to end all stimulus, not whether we should start to curtail it.
The fact that there is a debate about a quarter-point rate hike tells us that extraordinarily low interest rates have mostly failed to deliver a robust recovery. That people opposed to even the tiniest increase in rates are resorting to hyperbole tells us that they too know this. The thinking seems to be that six years into near-zero policy, the only reason it hasn’t worked is because it hasn’t been tried long enough.
Meanwhile, the dangerous side effects of year after year of artificially low rates continue to grow. Some asset markets have reached historically high valuations and investors have to keep reaching for riskier investments to earn a decent return. Savers continue to be deprived of interest income. Whatever good came from the policy prescription when the economy was ailing, the time has come to change the dosage.