(Bloomberg View) — With the recent market turmoil, the easy-money choir is again calling for the Federal Reserve to put off raising interest rates. But this could be dangerous to financial stability and the economy. It would only create more uncertainty and further distort the capital markets, delaying the return to sound economic growth based on market fundamentals.
After nine years of no rate hikes, it’s time to begin returning to normal. It’s true there’s no inflation. And, yes, the economy is middling. But neither of those conditions justifies maintaining the zero-bound interest policy.
Those who argue against raising rates rest their case on two arguments, both of which misunderstand the effects on the real economy and the financial markets. The first is that the economy and the labor market are still too weak. In particular, there is the concern that higher rates would stymie a housing-market recovery that’s one of the main drivers of current U.S. economic growth. But this concern is misplaced.
To be sure, certain parts of the housing market have not yet fully healed. But continued zero-bound interest rates can do little to help those heavily overbuilt and depressed areas. Meanwhile, in other areas, they may push some homes back up into valuations frothier than even those seen during the 2008 housing bubble. It would be safer to let the market set long-term interest rates.
Even then, an increase in the Fed’s short-term rates would probably have only a minimal effect. That’s what the market is telling us now. When the market is allowed to work, inflation expectations play a big role in determining long-term rates. And recent moves in the yield curve and mortgage rates suggest that these expectations are so low that long-term rates will also remain historically low. This, in turn, will keep the 30-year mortgage affordable. Moreover, to the extent that returning to a normal interest-rate policy affects inflation expectations, it may work to keep the long-term rates low. Consider that, in recent weeks, as the potential for a rate hike has looked more certain, long-term rates went down, suggesting that mortgage rates will remain low even if the fed funds rate rises.
In short, the data we have for housing and infrastructure investment suggest that the first 25, 50 or even 100 basis points of policy normalization will have very little to no effect on these activities and thus little or no effect on the real economy. If anything, a rate rise might help dampen a little of the froth that is evident in some markets. With home prices hovering at or above their 2008 highs, a little slowdown in price increases could be a good thing.
Those opposed to a rate rise also worry that it would further drive up the value of the dollar, hurting trade and stoking further turmoil in emerging markets. Yes, a further rise in the value of the dollar would add to the risk of capital flight from emerging markets. But capital is leaving emerging markets for many reasons that are unrelated to interest rate differentials or even emerging markets’ difficulty servicing their dollar-denominated debt.
The recent drops in emerging-market currencies are the first step in an inevitable adjustment process. Many emerging economies, particularly those that have come to depend on high commodity prices and demand from China, will need to regain competitiveness or seek to restructure their economies to better reflect supply and demand in the world economy. Maintaining a zero-bound interest rate in the U.S. will do little to dampen the pain of this adjustment.
Fears of an emerging-market crisis on the order of what happened in 1997-1998 are greatly exaggerated. By now, nearly all emerging economies have built up a healthy stock of foreign exchange reserves, and most have flexible exchange rates that will help them through the transition process. Yes, we will be in for a few bumpy months, but it would be better to endure some discomfort now than prolong the pain.
Those in favor of continuing the Fed’s zero-bound rate policy ignore the risk of side effects. Consumer prices and wage inflation aren’t a worry, but monetary policy has an effect on the real economy and thus on asset values and the allocation of capital, as the Bank for International Settlements recently pointed out.
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The great risk is that a further delay in the normalization of interest rates will further distort asset values and lead to an even greater misallocation of capital. Indeed, one of the purposes of the zero-bound policy was to lift asset prices and push savers to become investors. But rather than increase new capital investment, this policy has turned us all into stock-market junkies. It’s OK to want to get clean. Indeed, it is essential to our long-term economic health.
Finally, some argue that we should put off a rate increase in order to help calm the markets. But to do this would be to give in to our addiction. It has been the prolonged period of zero-bound interest rates, not the threat of a 25-basis-point hike, that has brought on the wild swings of the past week. It would be better to let the market re-price risk, taking a little of the froth off the top, than to try to maintain the froth.
Some short-term turbulence is to be expected, given the distortions that have accumulated as rates have been kept low. But the Fed only adds to that turbulence by keeping investors guessing about when it will change policy. That’s why the Fed should move at its upcoming meeting in September. A rate increase at this point would signal confidence in the economy and could thus help stabilize markets. More important, it would encourage more investment based on expectations of real economic growth and less stock-market speculation based on addiction to zero-bound rates.
The U.S. claims to have a market-based economy. Maybe policy makers should listen better to what the market is really telling them.