A Maverick at the Fed Wants to Raise Rates

(Aug. 14) -- Few economists, politicians, small-business owners or American unemployed who number in the millions would disagree with Thomas Hoenig's opening assertion at a town hall meeting in Lincoln, Neb.

"These are trying times," said Hoenig, a voting member of the Federal Reserve's interest rate-setting committee and president of the Kansas City Fed.

"Not in decades has the Federal Reserve seen such challenges in how it conducts monetary policy," Hoenig added, noting that the unemployment rate approaches 10 percent, that the financial system remains under stress, that community banks fail on a weekly basis and that the historically low interest rates aimed at fueling recovery also mean people who save their money are getting little return on it.

But Hoenig breaks with other top Fed officials, Wall Street and most of economically minded Washington over what to do about it.

He wants to end the Fed's open-ended promise of holding interest rates close to zero, arguing the policy of keeping the cost of borrowed money super cheap only adds to the uncertainty plaguing the economy and risks repeating the cycle of reckless boom and painful bust that wrought the financial crisis and recession.

"I wish free money was really free and that there was a painless way to move from severe recession and high leverage to robust and sustainable economic growth, but there is no shortcut," Hoenig told his Lincoln audience. "Monetary policy is a useful tool, but it cannot solve every problem faced by the United States today. In trying to use policy as a cure-all, we will repeat the cycle of severe recession and unemployment in a few short years by keeping rates too low for too long."

One Worry vs. Another

The policy-setting Federal Open Market Committee this week to no one's surprise kept its target for benchmark interest rates at the historically low level of zero to 1/4 percent. That's where the federal funds rate has been since December 2008, when the Fed and the Bush administration, desperate at the height of the crisis, were doing all they could to prevent a global meltdown from becoming a full-fledged depression.

Also to no one's surprise, the Fed stuck with language in its policy statement tacitly promising the "exceptionally low levels of the federal funds rate for an extended period." Most economists and players in the financial markets take that to mean it could be well into next year or even 2012 -- depending on economic conditions -- before the Fed starts to raise borrowing costs to normal levels.

Last week's unemployment report was the latest confirmation that the economic recovery has petered out, with job creation at an anemic pace and economic fears putting a freeze on the kind of consumer and business spending needed to build momentum for self-sustaining growth.

And it fanned fears at the Fed and elsewhere.

Asked if President Barack Obama is discouraged by the stubborn nature of the recovery, White House spokesman Robert Gibbs responded Friday, "Yes," as the president "has been for going on 18 months."

With interest rates already about as low as they can get, Fed Chairman Ben Bernanke and his colleagues have been scrambling to come up with other solutions, which so far includes a willingness to reinvest Fed cash in long-term government bonds in a bid to boost the amount of cash banks have available for loans. Some economists, like New York Times columnist Paul Krugman, an economics Nobel laureate, are calling on the Fed to take much bolder steps like buying mortgage-backed bonds as it did during the crisis.

To Hoenig, that is folly.

The Dangers of Deflation

As he has at every Fed meeting since January, Hoenig dissented this week, voting against the inclusion of the "extended period" language in the Fed statement, saying it limits the Fed to act as needed when the economy is still recovering, however slow that recovery has become.

And he went much farther today.

"If, in an attempt to add further fuel to the recovery, a zero interest rate is continued, it is as likely to be a negative as positive in that it brings its own unintended consequences and uncertainty," he said. "A zero policy rate during a crisis is understandable, but a zero rate after a year of recovery gives legitimacy to questions about the sustainability of the recovery and adds to uncertainty."

The low interest rates that followed past recessions in the early 1990s and opening years of this past decade contributed to the imbalances -- overspending by consumers and homebuyers, reckless risk taking by banks and investors -- and allowed household and government debt to perilously balloon to overwhelming levels, Hoenig argued.

Another historical parallel: A growing number of economists, Fed officials and the financial media are warning, as they did in 2003 following the last recession, that deflation -- the kind of downward spiraling of consumer prices that crippled Japan's economy in the 1990s -- now looms as a big threat, Hoenig noted. (Inflation, traditionally the biggest enemy of central banks, has all but officially been declared dormant in this time of economic malaise by Hoenig's colleagues at the Fed.)

But he sees no evidence of deflation.

Americans' Purchasing Power Wanes

Indeed, two reports from the Labor Department today may ease deflation fears.

One, the consumer price index, showed consumer prices rose by 0.3 percent in July, and a tame 0.1 percent when volatile energy and food costs are excluded.

The second report showed that not only is mild inflation present, in July it moved faster than growth in Americans' average hourly earnings. In other words, American workers' purchasing power diminished last month because prices rose faster than wages.

That slight wage growth, despite the unhealthy caution employers feel about hiring, and that uptick in prices, however small it is, are signs that the economy is growing even if the pace is not strong enough to get Americans back to work -- which is the most important economic measurement following a recession that cost more than 8.5 million jobs.

But the existence of any growth at all is part of Hoenig's point.

"In fact, we are experiencing a better pace of recovery this time than at this point in our previous two economic recoveries," he said. "We are recovering from a horrific set of shocks, and it will take time to right the ship."

'Hard Choices'

Hoenig isn't arguing that interest rates should be raised, at least not right away, since the economy remains very weak.

But the implicit guarantee of such low borrowing costs for an "extended period" needs to be dropped, he said, to tell "the market that it must again accept risks and lend if it wishes to earn a return."

Hoenig's idea, in a talk he titled "Hard Choices," is that the Fed could announce a gradual rise of interest rates toward 1 percent -- still extremely low by historical standards -- in a given time frame, after which the bank could pause and give the economy time to adjust. And when the time is ripe, rates could be raised again.

It seems an unlikely direction for policy at the Fed, where Hoenig remains the sole dissenter.

But the central bank has been moving in and out of charted territory for monetary policy for nearly two years now. And no one watching the Fed or making decisions there is sure just what it will do next.