Jim Kudlinski: The Fed is inching toward increasing interest rates — and shouldn’t waste any time

08/25/2014 9:36 PM

08/26/2014 6:07 PM

The Federal Open Market Committee release on August 20 was a tiny step in the right direction  — notifying us that they are now considering increasing interest rates slightly more than they were at their previous meeting.

This is an indication that the Fed, and especially the hawks on the FOMC, are uneasy about maintaining rates at abnormally low levels in the pursuit of teasing out the last shred of economic growth from such a policy — because they recognize a miscalculation on their part could be catastrophic. And they are now near or at the precipice where a wrong decision could enable inflation to gain a foothold, something which they don’t want and we cannot afford.

The rate of inflation measure used by the Fed is now bumping against 2 percent, their trigger point for initiating defensive measures, i.e., raising rates. And since the Fed’s measure does not include the full effects of the food and energy components, it gives us all reason to pause and contemplate whether further delay in the Fed’s actions to dampen threatening inflationary forces is warranted.

The Fed has experience with inflation getting out of hand as it did, for example, during former Fed Chair Burns’ tenure in 1974, when it reached a level of 11 percent. Burns was effective in moderating it to 5.8 percent in the following two years, but inflation again began to rear it’s ugly head and returned to 11.3 percent during his replacement, former Fed Chair Miller’s brief 17 month tenure. President Carter then sought Paul Volcker, President of the New York Fed Bank, for the Fed’s Chair and he accepted, but not before Volcker made clear his intentions to raise rates to whatever levels and time interval required to extinguish inflation and all of its embers. President Carter told him that’s what he wanted. Inflation peaked at 13.5 percent in 1980 before Volcker’s super aggressive and punishing monetary policy began to dampen inflation that had our nation in its grasps.

But the costs of extinguishing it were prohibitive. During Volcker’s 8 year tenure (1979-1987) he drove rates into the stratosphere to expunge these destructive forces. Interest rates on a 1 year CD peaked at well over 16 percent. Mortgage rates on a 30-year residential loan were above 14 percent. Fed Funds traded at double digits ( and there were many days when the range of trading was from 2-35 percent). Our government’s cost of funds reached double digits.These high rates shut down consumption and investment and resulted in unemployment peaking at 9.7 percent in 1982 and 1983. Small businesses, entrepreneurs, and contractors failed daily.

The country protested. Builders flooded Volcker’s office with 1 foot sections of 2 by 4’s, which they mailed and were delivered by the Postal service each morning. Truckers parked their vehicles throughout Washington, DC in strategic locations to totally stop traffic in the nation’s capital. Many comments were voiced that it is unreasonable to permit such few unelected officials to cause so much pain to so many (referring to the seven members of the Fed Board).

How did we get into that mess? When inflation shows up in the numbers, you are already too late. And once inflation gets seated, it is difficult to eradicate. Monetary policy is not a science. It’s not even an art. It’s a matter of judgment, action, and reaction. You turn the spigot on (eg., raise Fed Funds 1/4 percent) and it takes up to 2.5 years to see the results in the economy. And before you know the results from this one action, you may have to make several more, not knowing the result from any of them. This is one of many reasons why it is difficult to extinguish inflation after it has reared its ugly head.

We have a $17 trillion deficit which now costs our government less than 2 percent annually to fund. If our government’s cost of funds again reaches double digits as it did during Volcker’s tenure, we may as well turn off the lights. We cannot afford $1.7 trillion in our annual budget just to fund our nation’s debt. The Fed should not attempt to squeeze the last drop of benefit from abnormally low rates. The benefits to be gained are small as compared to the costs if inflation gets a hold. We are still emerging from the effects of the subprime mortgage fiasco. Let’s not risk imposing another one on top of it.

Jim Kudlinski, PhD, Director, Division of Reserve Bank Operations, Federal Reserve Board (1971-1981), author of “The Tarnished Fed”, Overland Park, Kansas, 913-469-8592

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