Bailout

Can the Fed raise rates earlier than expected?

By Felix Salmon

Krishna Guha reads the Fed tea-leaves:

The central bank has made it clear it does not expect to raise rates any time soon - saying in its last statement that it sees rates remaining near zero for an “extended period”.

It subsequently extended most of its emergency liquidity facilities to February 2010, a signal that it believes a rate rise by then is highly unlikely.

I’m sure this is true — but at the same time I see no reason why the Fed can’t start raising rates while the emergency liquidity facilities and other artifacts of quantitative easing remain in place.

At the margin, a Fed funds rate at 1% or 1.5% is not going to put much in the way of a visible brake on economic growth — especially not so long as all the Fed’s liquidity facilities are still up and running. But by raising short-term interest rates in the Fed funds market, and by keeping long-term interest rates low through quantitative easing, the Fed would be able to act much more decisively if and when inflation fears really started to appear.

One of Alan Greenspan’s biggest errors was his decision to raise rates only very gradually even as the housing bubble was gaining full force — there are serious practical constraints on the Fed hiking by more than 50bp at a go. So it might make sense to have a bit of a headstart, as it were: by starting to raise rates at the beginning of 2010, the Fed might be able to make them really felt once the tightening cycle started up in earnest. In the meantime, by artificially keeping long-term rates low, the Fed would manage to maintain its accommodative stance.

Guha points out that the Fed funds futures market, until a few weeks ago, was pricing in a Fed rate rise this year; it’s still pricing in some tightening by February. I don’t necessarily think that’s going to happen. But I do think it’s possible.

Full post as published by Macroprudential on June 30, 2009 (boomark / email).