The stock market turmoil of this week and last has led some to believe/argue that the Federal Reserve will/should not increase short term interest rates at its September meeting. In The Wall Street Journal this week, Martin Feldstein said this:
“Mr. Bernanke explained [in 2009] that the Fed’s [unconventional monetary] policy [i.e., of holding short-term interest rates near zero] was designed to drive down long-term interest rates, inducing portfolio investors to shift from bonds to stocks. This ‘portfolio substitution’ strategy, as he labeled it, would increase share prices, raising household wealth and therefore consumer spending. …
With virtually no yield available on government bonds and other low-risk fixed-income securities, investors were tempted to climb on the bandwagon of rising share prices. Some sophisticated investors realized that the rapid increase of share prices was a bubble that would end when interest rates returned to normal. They invested on the mistaken theory that they would know when to pull out. …
Much of this mispricing will likely unwind in the months ahead. …
The market decline will no doubt lead some members of the Fed’s Open Market Committee to argue against beginning the rise in short-term rates in September. But postponing a 25-basis-point rise from September to December or even March would not have any significant effect on aggregate demand and employment.
Market participants know that the economy is now essentially at full employment, that the consumer-price index is close to 2% and that there is little risk of deflation. They know therefore that interest rates must rise, and that a return to normal levels will reverse the mispricing of assets. The Fed cannot hide that realization by postponing rate hikes for a few months.”
The idea of postponing an increase in interest rates is, at least for some, based on the “one more bubble” theory that I talked about last October.
I sort of wonder, however, whether a 0.25% increase in interest rates would make any real difference in business decisions. I find it hard to believe businesses would not do something because interest rates are ¼% higher. The idea must not have been that good, if ¼% makes a difference.
Unless it is about psychology, and the idea is, if the Fed starts to raise interest rates, even a little, that is a signal the Fed is going to start going back to a more market-based level for asset prices, instead of a policy favoring artificially high asset prices resulting from artificially low interest rates. In other words, an interest rate increase of even just ¼% would be a sign the Fed was, at long last, starting to take the “one more bubble” hope off the table.
That might depressing to some in the short run, but it would be good in the long run. And in response to those, like Lord Keynes, who say “In the long run we are all dead,” I would simply say that our children and grandchildren aren’t.*
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* I cannot claim credit for this response, but that doesn't make it any less true.
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