Don't Fear Higher Interest Rates, Welcome Them

(MoneyWatch) 

The Federal Reserve's Board of Governors is widely expected when it meets this week to keep its benchmark interest rate at the record low level, near zero, it's been at since December. With that, Wall Street will again find reason to be cheerful, but it's hardly cause to celebrate.

The Fed's cheap-money policy is helping the U.S. get out of its crippling economic slump, and there's room for the nation's central bank to keep the rate low for a while longer. The 3.5% third-quarter GDP growth rate reported last week confirmed the recovery is underway, but it is just one quarter.

Fed watchers are divided as to when they think Chairman Ben Bernanke & Co. will again begin raising rates. Some project it will be as early as spring; others suggest it might not be until 2011. If recent history is any guide, it will probably be later than sooner: The last upward cycle in the Federal Funds Rate began in July, 2004 ?€"- 2 1/2 years after the much shallower 2001 recession officially ended.

What's important to realize is that, when the rate-hiking cycle begins, it really will be a welcome development. Don't worry that Wall Street initially sells off on the shift; it just recalibrates anticipating moderation in growth.

To understand the role interest-rate setting plays in the economy, here's how it works: Lower interest rates stimulate demand for products and services. Set rates too low -?€" and especially for too long ?€"- and you over-stimulate demand, leading to supply shortages. That in turn leads producers and providers to boost prices, which leads to inflation. In order to put the kibosh on an "inflationary spiral," the Fed boosts interest rates to cool demand.

With its benchmark rate at near zero, the Fed doesn't have any means to further cut rates to stimulate demand if the economy falters again. A rise in rates will signal that the Fed believes the economy is in expansion mode -- rather than just in recovery -- and will rearm the Fed with an economic stimulus tool should the economy again falter.

Ultra-low interest rates fuel growth and if the economic engine is running strong, it doesn't need that fuel additive. Don't fear whenever that first rate hike occurs. Celebrate it, because that means the recession will be far behind us.