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Should the Federal Reserve raise interest rates?

As the U.S. economy continues on the slow road to recovery, the Federal Reserve must decide when to begin raising interest rates. Many forecasters predict the central bank will pull the trigger by year-end, perhaps when Fed officials congregate for their scheduled policy meeting in September.

Some economists, such as Stanford University's John Taylor, believe the Fed should have already started reversing its low interest rate policy. Others, including Chicago Federal Reserve Bank president Charles Evans, are just as convinced that the Fed should be patient and delay any increase until at least the beginning of next year .

So what are the arguments for and against an immediate increase in the federal funds rate, which is how much banks charge each other for a short-term loan?

Arguments for raising interest rates now

Those who argue for an immediate rate increase are concerned about two things -- inflation and instability in financial markets. The worry about inflation arises from the fact that the Fed lowers the target interest rate by adding reserves to the banking system. Presently, these reserves are mostly held by banks -- think of it as cash piling up inside of bank vaults -- and as the following figure shows, reserves have increased by trillions since the start of the Great Recession. That has pushed the target rate to near zero.

Fred-reserves

These reserves could be used to make loans to businesses or households rather than sitting idle inside of the banks. But with interest rates so low and economic conditions less than optimal, banks have chosen to hold onto the money rather than lend it out. The Fed pays banks interest of 0.25 percent on their reserves. That is higher than the net return (after defaults, for example) banks would expect to get from making loans.

However, as economic conditions improve and the expected return on bank loans increases, banks may choose to begin loaning these reserves in larger amounts, and the resulting increase in demand could spark inflation. Once inflation takes hold, it can be very difficult to reverse.

The other worry is about instability in the financial sector. The concern here is that when interest rates are very low, as they are now, investors will embark on a "search for yield" that causes them to pursue risky investments with the potential of high returns. If this happens on a large scale, the increasing risk that the average investor takes on could put the financial system in danger.

Arguments against an immediate hike in interest rates

Those who believe that interest rates should stay low, at least for now, believe the risks associated with raising interest rates are asymmetric; that concerns about inflation and financial market instability are overblown; and that even if there are bubbles in financial markets, interest rate increases are the wrong way to attack them.

The idea behind the asymmetric risk argument is that raising interest rates too soon -- meaning before the economy is close enough to full employment -- could make an already slow recovery even slower, and perhaps even cause another recession. Conversely, waiting too long to begin raising interest rates could risk an outburst of inflation.

Which path is riskier? Higher unemployment due to a slower recovery is very costly, much more so than a temporary increase in inflation (proponents of this view don't believe a bout of inflation would be hard to reverse). In addition, the risk of inflation is low.

Those who favor raising interest rates in the near term -- the inflation "hawks," as they are known -- have been predicting inflation ever since the Fed began easing policy more than five years ago. Again and again we've heard that inflation is just around the corner, but so far it has not materialized.

Those who believe the Fed should be patient in raising rates argue that inflation hawks are greatly overstating the risks. And if inflation does become a threat -- if reserves begin leaving the banking system in large amounts -- the Fed can keep money inside the banks by raising how much it pays banks to hold reserves.

As for the argument that interest rates should be increased to reduce the chance of instability in the financial sector, those opposed to immediate interest rate increases see little sign of dangerous bubbles developing in financial markets. But even if there were such signs, many people think that raising interest rates are the wrong way to respond. Increases in interest rates affect all financial markets, not just the few that are having problems, and it is a very blunt instrument in any case. It is much better, according to this argument, to attack individual problems with regulation targeted at specific problems.

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