Video: Should the Fed raise rates now?

By John W. Schoen Senior producer
msnbc.com
updated 4/11/2010 1:24:34 PM ET 2010-04-11T17:24:34

The Federal Reserve is caught in one of the thorniest dilemmas of its 97-year history — a predicament it had a hand in creating.

To tighten or not to tighten? That is its question.

After successfully calming one of the worst financial panics in history with a massive infusion of money in the fall of 2008, the Fed now faces an equally challenging problem — how to drain all that cash from the system and begin raising interest rates.

The issue was brought into sharper focus this week following a speech by Kansas City Fed President Thomas Hoenig, who said the central bank should raise rates “soon.”

But raising rates too soon could snuff out a weak economic recovery that has yet to take hold convincingly. Waiting too long, however, could fuel another financial bubble, much like the one that created the panic in the first place.

The risks of waiting, Hoenig told a luncheon gathering in Santa Fe, N.M., “all too often seem more distant and less compelling, and therefore hold great long-term danger for us all.”

Since its creation in 1913, the Fed has walked a policy tightrope: making sure the economy has enough credit to prosper without letting money get so cheap that inflation takes hold.

But in the fall of 2008 central bankers faced a different problem, one not seen for decades: a full-blown, global financial meltdown not unlike the Panic of 1907 that prompted Congress to create the Federal Reserve system in the first place.

In some ways, the decision to put out the fire by flooding the system with over $1 trillion was fairly straightforward. The current decision on when and whether to begin mopping up that cash puts the Fed in a quandary.

The case for sticking with the current “easy money” policy isn’t hard to make.

Although the job market perked up convincingly last month for the first time since the recession began in December 2007, the recovery is still extremely fragile. The housing market seems to be stabilizing but remains weak. Bank lending is still sluggish, and consumers are borrowing less. Inflation remains low.

Major Market Indices

All of which suggests to some economists that the most prudent policy is to keep the Fed's main benchmark short-term rate close to zero until the recovery is better established.

“Now is not the time to remove the monetary punch bowl,” said Scott Anderson, a senior economist at Wells Fargo. “We've still got an unemployment rate in this country that's near 30-year highs. The amount of slack in the economy is still well below historical averages. So I think the Fed still has plenty of time to tighten monetary policy.”

But others say that's just the kind of thinking that created the housing bubble of the last decade.

Some see a new bubble inflating as stock prices rise in a lackluster recovery. Despite weak demand from a sluggish global economy, oil and precious metal prices also are rising. Demand for those commodities appears to be driven at least partly by investors, and not by industry.

“When you penalize folks for being in cash you force them into risk-seeking behaviors,” said Dean Curnutt, president at Macro Risk Advisors. “Our concern is that a substantial portion of this (stock market) rally is a function is of the incredibly stimulative policy from the Fed.”

The Fed’s easy-money policy is designed to help the nation’s banking system fill the giant hole in its capital base created by huge mortgage-related bets that went bad. But leaving too much money in the system for too long could prompt bankers to once again take on too much risk.

"I am convinced that the time is right to put the market on notice that it must again manage its risk, be accountable for its actions,” the Fed's Hoenig said in his speech.

If all that weren’t enough, the Fed also faces a quandary it has never dealt with in its history. When the panic struck in 2008, the central bank seized on an obscure section in its charter giving it the power to vastly expand its lending powers “in exigent circumstances.” The result is that it now owns a $1.25 trillion portfolio of bonds backed by home mortgages, which it only recently stopped accumulating. Until it unwinds that portfolio, it will be difficult to restore normalcy to the mortgage market and the wider financial system.

Some central bankers think the Fed needs to begin selling off those mortgage bonds before considering a rate hike.

“To my mind, I think reducing reserves before we raise rates makes a lot of sense,” Jeffrey Lacker, president of the Federal Reserve Bank of Richmond, told CNBC this week. “I think there's a lot of good arguments for that. But we're still hashing out the pros and cons of various approaches.”

Selling off over $1 trillion in mortgage bonds carries another set of risks. Until it’s clear the mortgage market is back on its feet, unloading that much debt could snuff out the fragile recovery in the housing market, sending the economy back on downward slide. On Thursday, the average rate on 30-year mortgage hit an 8-month high of 5.21 percent, according to the latest weekly survey by Freddie Mac.

That upward move reflects rising market interest rates that are possible even without action by the Fed, which has direct control mostly over short-term rates. With federal and state budget deficits swelling, increased demand for borrowing is driving up the cost of money on the global bond market already.

“We’re seeing this with Greece, of course,” said Curnutt of Macro Risk Advisors. “At some point the bond market vigilantes, so to speak, impose austerity on state and local governments with respect to their debt and at the federal level as well.”

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