Why the Fed Should Boost Interest Rates

Categories economics, monetary policy

If the Fed wants to boost economic activity, it should think about raising the federal funds target rate. Why? Wouldn’t that restrict lending? Paradoxically, it would likely increase lending.

This would force banks to engage in more lending in order to make a profit. Currently, banks can make money doing virtually nothing, as they borrow money from the Fed at zero percent interest and use that money to buy government bonds yielding 2-3%. This blog makes the same point. If banks can make a profit without risk — because government bonds carry no risk — then why lend at risk? But if the Fed raises its rates, then this margin will shrink and banks will be forced to engage in riskier activity, such as lending to business and consumers. Perhaps then, as the big banks move away from risk aversion, interbank rates would drop, facilitating borrowing across the board.

The argument is that raising rates will plunge the economy into a depression. With bonds trading at yields of less than 2%, bond markets, it is said, are signalling that inflation is dead. But is this not to reverse the actual situation? Are bonds not trading at this low a level because the baseline rate is zero? Raise the rate, and these short-term rates will also rise. This will simply have the effect of flattening the yield curve — 30-year rates remain stubbornly above 3 1/2%. As long as the yield curve does not invert, is there a problem with that?

St. Louis Fed chairman Thomas Hoenig has been arguing for some time that the federal funds rate needs to be moved out of the zero percent range. His argument makes sense. The Fed can do more to boost economic activity than lower rates.