Fed Conflicted Over Interest Rates, Strength of Economy

Who are we -- as consumers, as an economy -- after the financial crisis? Are we back at the mall, credit card at the ready; or are we holed up at home clipping coupons and squirreling away our pennies? Is the ice cream parlor down the street staffing up in anticipation of a strong summer season, or is it cutting its already lean payroll even further?

For answers to these and other questions about the direction of the economy, one would normally look no farther than the Federal Reserve. Except that even the central bank seems unsure. Fed Chairman Ben Bernanke certainly acts as if we're not out of the woods. Others -- call them the Debt Hawks -- think the economy is solid enough to withstand an interest rate hike.

Bernanke said last month that rates would remain low for an "extended period," suggesting his wariness of hurting the economy as it's starting to rebound. This view generally assumes, among other things, that corporate profits over the next several quarters will be modest and that high unemployment will persist for some time to come. It also sees continued government spending and cheap money as the best antidote for feeble growth.

Atlanta Fed chief Dennis Lockhart is also focused on not doing anything to overturn the economy, such as raising fears about a sudden interest rate increase. In a speech Thursday he called for a "nimble" monetary policy that follows the course of the economy. For now, the fragile recovery weighs in favor of keeping rates low, he said.

We are forecasting a lower-growth, more gradual recovery with slow progress on unemployment. Our outlook gives weight to some challenges facing the economy and the banking sector that we believe may constrain recovery.... I expect businesses to be very cautious with respect to inventory accumulation, capital spending and hiring.

By contrast, Kansas City Fed President Thomas Hoenig thinks the economy is ready to stand on its own and, as such, that the Fed should at least signal its willingness to lift rates in the near term. Under this view, the greatest risk isn't sluggish economic activity, but the nation's soaring debt. In a speech in Washington earlier this week, Hoenig warned that excessively loose monetary policy could eventually trigger "hyperinflation":

Congressional Budget Office projections have the federal debt reaching an unsustainable level of two to five times our total national income within the next 50 years, which leads us to an inescapable conclusion -- U.S. fiscal policy must focus on reducing this debt build-up and its consequences.

Hoenig's fears about runaway deficits are well-grounded. But economic indicators bear out Lockhart's concerns about snuffing out growth.

For one thing, inflation remains under control. That means the Fed faces no immediate pressure to tweak rates. Perhaps more important, the jobs picture looks bleak, as businesses keep their powder dry. Unlike the 2001-03 recession, when unemployment peaked at 6.3 percent and fell quickly, signs suggest it will remain elevated for years.

That has grave implications for the financial industry. One problem with jobless recoveries is that people can't climb out of debt, including catching up on their credit card and mortgage payments.

So where do we go from here? You got me. Some interpret the Fed's surprise move yesterday to raise the "discount rate," which is what it charges banks for short-term loans, as the agency's setting the stage for a broader rate-hike. Maybe. But it's more likely that Bernanke is simply reinforcing his message that the days of unconditional federal support for Big Finance are over.

Money management guru David Kotok may have the best theory on the Fed's latest move. He says raising the discount rate is a way for the Fed to inject a little uncertainty into the market. Under this view, forcing investors to factor even the possibility of a near-term rate increase is a subtle way of reining in growth.