The Economy Will Be Better Off When the Fed Does Less

The government and the Federal Reserve have spent trillions of dollars and tried many old and several new monetary policies in mostly futile attempts to stimulate the economy and increase the speed and strength of the recovery from the 2007-2009 recession. One aspect of all these actions has been the approximately zero interest rates that the Fed has been using in the hope of increasing credit. Now, finally, a growing chorus of voices is calling for a quicker return to more normal interest rates.

Officially the Fed is still putting language in their statements that interest rates will be held low for a considerable period of time and markets are betting that rates will not start to rise slowly until mid-2015. Two regional Fed presidents along with David Malpass of Forbes have all recently suggested that higher rates would be beneficial either now or sooner than the Fed seems to want to act.

Charles Plosser of the Philadelphia Fed has called for removing the promise to keep rates low for a considerable time and wants to see rates rise starting now. Richard Fisher of the Dallas Fed is warning of the dangers to the economy of low rates that cause monetary policy to stay "too loose, too long." David Malpass points out that higher rates would help revive the interbank credit market, thereby increasing available credit, would help markets allocate capital more efficiently, and would allow savers to finally earn some money on those savings.

The Fed continues to have a solid majority in favor of low rates with no plan to raise them until they are convinced that the labor market has sufficient strength. Unfortunately for the economy, the Fed thinks low rates have only good effects on the economy and that raising them is something to be done when the economy needs no more help. In reality, as the aforementioned people realize, higher rates have positive effects, too.

Low interest rates increase demand for loans (although I would argue that past a point, lower rates do not induce further increases in loan demand), but those same low rates also discourage the saving needed to produce a supply of loans. The Fed has helped create a supply of loanable funds through its quantitative easing program and U.S. credit markets have also benefited from a flight to safety of international funds. If rates were allowed to rise, regular people would have a reason to save again, meaning there would be money available to loan out without a need for extraordinary monetary policy or international turmoil to provide liquidity for our credit markets.

While low interest rates have allowed many borrowers to decrease their borrowing costs and thereby increase their purchasing power, they have simultaneously reduced the income of savers which lowers their purchasing power by an amount roughly equivalent to the boost given to the borrowers.

Additionally, low interest rates have the side effect of making it easier for governments to run large deficits. More government spending, enabled by the low interest rates, is not helpful. Rather it leads to wasteful spending and lower social welfare as public projects with below market rates of return proliferate.

Whenever policy makers talk about the benefits of a policy, one needs to think about the cost. Low interest rates may provide benefits, but they are not free. Raising rates at this point in the recovery is likely to produce more benefits than costs. More normal interest rates will improve the functioning of free markets leading to higher economic growth.

We cannot be in extraordinary times forever. This recovery is already longer than the post-war average. It is past time for the government and the Fed to return to normal economic policy. If they try to help us less, we will be much better off.