Tuesday, September 8, 2015

Should The Fed Raise Interest Rates Part Two?

The Fed has to make difficult decisions in order to satisfy its three major missions.  It has a mandate to provide price and employment stability while maintaining the stability of the financial system.  Joseph Stiglitz argues that this should be an easy decision for the Fed.  Ordinarily, the Fed would increase interest rates if it were worried about a rise in inflation.  That decreases economic activity and the demand for labor.  That prevents a rise in wages which puts an upward pressure on prices.  Stiglitz does not see any evidence of inflation, and he argues that the Fed's 2% target rate for inflation may be too low under current circumstances.  A bit more inflation would be a good thing and so would moderate growth in wages which have been stagnant for most Americans.  He also minimizes the risk to financial stability that may be associated with low interest rates.  Low interest rates encourage investors to take on more risk when the yields on risk free US bonds are close to zero.

Carmen Reinhart makes a slightly different case for a more gradual approach by the Fed.  She argues that there is a greater threat of price deflation in most developed countries.  The inflation rate in most developed countries is below the 2% target held by central banks.

These discussions raise a question about the extraordinary policies adopted by the Fed and the ECB in Europe.  Quantitative easing has kept interest rates low but they have not had much of an impact on economic activity.  Central banks have been fighting a losing battle against price deflation and low wage growth because contractionary fiscal policies have diluted the effect of low interest rates.

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