Why the Federal Reserve's policy of keeping short-term interest at historic lows has such broad support
It's remarkable, really. The Federal Reserve is holding short-term interest rates at the lowest levels in history—zero to 0.25%—even though the economy is showing signs of recovery. Some critics argue these ultra-low rates will trigger a dollar crisis or fuel financial speculation that will end, once again, in tears. Yet the engineer of these low rates, Fed Chairman Ben Bernanke, has retained the confidence of the financial markets and fellow policymakers. On Aug. 25, President Barack Obama said he will reappoint Bernanke to another four-year term as chairman. If confirmed by the Senate, he would remain at the helm through January 2014.
How has Bernanke managed to win support for keeping interest rates at rock bottom, even though the easy-money policy he advocated in 2002-04 helped inflate the bubble that burst disastrously just a few years later? The answer is simple: Bernanke has succeeded in persuading most fellow economists—and, crucially, the bond market—that continued low rates pose no immediate risk of inflation and are in fact essential to keeping the U.S. economy from suffering a double-dip, W-shaped recession.
Not a single member of the rate-setting Federal Open Market Committee—which includes inflation hawks such as Richmond Fed President Jeffrey M. Lacker—dissented from the August vote to maintain low rates. Bernanke's grip on policy has only been strengthened in recent days by Obama's endorsement as well as support from other central bankers at the Fed's August conclave in Jackson Hole, Wyo.
Despite chatter about the Fed's urgent need for an "exit strategy," traders in the money market expect the funds rate to remain at 0.25% or below through next January or March before drifting up to 1% by summer, according to data from Bloomberg. And the likelihood of continued cheap money isn't alarming the bond market, which hates inflation. Yields on 30-year Treasuries have fallen slightly over the past month. Rates on inflation-protected Treasuries show no signs of mounting inflation anxiety.
Sure, it's easy to find people who think Bernanke needs to hike rates. Peter Schiff, president of brokerage Euro Pacific Capital, says that by nominating Bernanke for another term Obama is "rewarding failure," adding that "the cost [of low rates] will be a major currency crisis which undermines what remains of our economy." John E. Lekas, senior portfolio manager of the Leader Short-Term Bond Fund, argues that the Fed will be forced to raise short-term rates drastically in the next two years to keep foreign creditors content and prevent a dollar collapse.
But David G. Blanchflower, a Darmouth College economist who was until June a member of the Bank of England's Monetary Policy Committee, says Bernanke is correct to believe the global financial crisis remains dangerous. "It ain't over, babes," says Blanchflower.
LICENSE TO CONTINUE
On Wall Street, few economists or traders worry that rates need to rise soon. Excess capacity will keep a lid on prices for a long time to come, says Larry Kantor, head of research at Barclays Capital in New York. The Fed doesn't need to raise rates to defend the dollar, either, because the recession has actually reduced net U.S. borrowing needs, says JPMorgan Chase (JPM) chief economist Bruce Kasman.
With an implicit endorsement from the bond vigilantes—and now an explicit one from the President—Chairman Bernanke has the license to pursue his low-rate policy for as long as it takes to get the American economy back on track.