Why a Fed rate hike now would help more than hurt

The great guessing game among investors these days concerns when exactly the Federal Reserve will finally start the next cycle of short-term rate hikes. But it's widely taken for granted that when it happens, it will take some wind out of the U.S. economy's sails. However, according to a research paper released recently by J.P. Morgan Asset Management, that view is wrong at this time.

It's generally true that raising interest rates can have a negative effect on prices, long-term asset values and U.S. exports. Higher interest rates make saving money more attractive and make borrowing more expensive. Consumers will likely forgo some major purchases, and businesses will delay investment projects, thereby slowing economic activity.

Higher rates can also reduce how many people qualify for a home mortgage, thus cooling off the housing market, which is a powerful engine for American economic growth. Higher interest rates also increase demand for U.S. dollars, boosting the value of the greenback, making U.S. exports more expensive to foreign importers and thereby curtailing U.S. exports.

But all of this typically happens only when interest rates are increased from levels that are closer to "normal" or when they're at already high levels. The central point the J.P. Morgan research makes is that when rates are increased from historically low levels, or from zero (where they are now), the initial moves can actually help improve economic growth rather than slow it. Here are the three main reasons it puts forth:

Higher interest income: Savers will finally begin to receive more interest income from their savings. And while costs on some consumer loans could rise, most loans today have already been converted to low fixed-rate loans, which won't change when rates rise. In the household sector, the amount of interest-bearing savings is estimated to be much larger than the total amount of variable-rate loans. Therefore, higher rates would have a net positive effect on the income of U.S. households.

Higher expectations: When the Fed increases interest rates and signals more hikes to come, households and businesses may try to make purchases sooner, taking out new loans in advance of any further rate increases. This increased loan demand should boost consumption and investment, lifting growth and jobs.

Higher confidence: As the financial crisis showed, nothing is more important to the U.S. economy than confidence. A Fed rate hike signals to everybody that monetary policymakers are confident in the economy's health, and everybody else should be, too. This should help boost consumer and business confidence, leading both groups to spend more. It's only when the Fed increases rates from an already high level to fight inflation that businesses and consumers cut back on spending in anticipation of a weaker economy.

  • Ray Martin

    View all articles by Ray Martin on CBS MoneyWatch»
    Ray Martin has been a practicing financial advisor since 1986, providing financial guidance and advice to individuals. He has appeared regularly as a contributor on the CBS Early Show, CBS NewsPath, as a columnist on CBS Moneywatch.com and on NBC-TV's morning newscast TODAY. He has also appeared on the Oprah Winfrey Show and is the author of two books.