Interest Rate Indecision in 2010 Could Make 2009 Look Like 'The Good Old Times'

Notwithstanding a good friend's spring 2009 prediction that inflation would hit double digits by February 2010, prices have been relatively tame over the past year, kept in check by reduced demand for fuel and goods in a recessionary environment. However, one of the biggest questions of the new year, assuming optimistically that both corporate and consumer spending continue and that unemployment drops, is the following; what will be the result of running the Treasury's printing presses non-stop over the past year as the US government attempted to avoid the worst of a banking crisis?

A classic result of printing money is the onset of inflation. As a stated goal of the keepers of the US economy is to avoid inflationary pressures, it is possible that a few options will be discussed, however, given the current state of things, not all of them are feasible. For example, at this point, it would appear that fiscal measures are out of the question, as reduced spending is not likely to be the cornerstone of economic policy in an election year and as stimulus has been so touted as a key to success by the current administration. Additionally, it does not seem likely that the Treasury will stop printing money.

Therefore, the answer to the above question depends in large part on the future plans of the Fed. Though it cannot actually ease further, as interest rates are just about as low as they can possibly be in their current range, the Fed can continue to keep rates as they are, a move akin to loosening monetary policy. This will ultimately have an inflationary impact, as money supply remains high. The other move that could be made would be to increase interest rates, a strategy bound to be unpopular among those who believe we are in the nascent throes of recovery as well as Democratic incumbents gearing up for critical election fights during the year.

However, there is a saying that gets thrown around in law school that 'easy cases make bad law,' a statement which can easily be re-written for use in this case as easy financial decisions lead to a bad economy. Here, this would mean raising rates now despite the minimal pain it would cause in order to avoid disaster in the future. Such action would have the impact of marginally reducing the money supply, and thus any excess liquidity by increasing the savings rate. The effect would be a curb on inflationary pressures. More importantly, it would also allow the Fed to maintain greater future control of the economy, despite being a difficult sell for short-sighted politicians.

Ben Bernanke should do everything in his power to convince lawmakers that measure tightening is the best course of action for the economy. Pointing to the not so distant past could be one strategy. Notably, a prolonged period of low rates in the late nineties, and more consequentially in the early 2000's, created by the 'wizardry' of Alan Greenspan, lead directly to the housing bubbles and the current malaise. Though the currently easing cycle was critical in the fight to stave off crisis, and the rapidity and creativity of reactionary solutions promulgated by the Fed in the face of collapse were commendable, the wait and see approach currently being taken by the bank is the yeast in the fermentation process of future asset bubbles and inflationary pressures. Bernanke, a student of the great depression, should certainly be able to see this, and is hopefully only waiting for a few economic triggers to put a tightening strategy in place.

Though this may seem counterintuitive while unemployment is still high, there is plenty of room to move on interest rates before they become inhibitive to corporate spending and thus hiring. Additionally, the alternatives could prove to be much more disastrous. China, for example, has been making a lot of noise regarding its inability to absorb much more US debt going forward, understandable considering the astronomical wealth it has tied up in US assets. Other nations are bound to reduce purchases of Treasury assets as well, due to the fact that with decreased US corporate spending, the pool of dollars available to purchase dollar-based assets has shrunk recently. Though this may seem odd since so much money has been printed over the past year, one must consider that a large portion of that went to merely shoring up battered balance sheets and bailing out money pits in Detroit. Finally, the stated desire of OPEC nations to reduce reliance upon the dollar is yet another concern in the current climate.

The fact that it is currently so easy for the US to sell debt even at marginal rates of return is directly due to the dollar's status as the global currency of exchange as well as the relative safety of the investment. However, if, for the above reasons and others, foreigners were to reduce the rate at which they purchase US debt, it could be disastrous for the US economy. Initially, the government would have a very difficult time putting some of its current plans, such as healthcare, into place. Therefore, it would need to take fiscal measures to increase revenue and borrowing. This means, for one, higher taxes with their detrimental impact on both corporate and consumer spending. Additionally, in order to entice further lending, the US would ultimately need to raise rates dramatically in the future, rather than at a measured rate now, offering a premium to get investors to bite. This would result in a much more rapid tightening process than either the Fed or corporate America would be happy with at just the time that spending is slowing down, conditions which could easily lead to deflationary pressures. And, with liquidity already high and stimulus out of the question, the government and Fed would have few tools available to fight such forces. Higher rates now would work to ward off inflationary pressures and avoid the disastrous impact of the faucet of lending to the US being shut off completely.

Though a tough sell politically, it is likely that efforts to keep rates low now will simply mean higher taxes and rates in the future, and ultimately an externally enforced, rather than an internally imposed, tightening. Then, fears of deflation could replace current concerns about inflation as the main evil of the day. To stave off future pain, the Fed will have to swallow the bitter pills of measured rate hikes. Otherwise the US economy will unfortunately have more to fear than 10% unemployment.