Time for rate increases is approaching

Near-zero policy interest rates are powerful. If the claims of financial economists are to be believed, they are holding up economic activity and bank balance sheets. But their magic isn’t only beneficial. They also distort behaviour in dangerous ways.

By Edward Hadas, Breakingviews.com
Published: 1:13PM BST 14 Oct 2009

The US Federal Reserve, still the world leader in central banking, has kept its overnight policy rate at 0pc-0.25pc for 10 months and is in no hurry to change. Ultra-low rates will be needed for an “extended period”, says Donald Kohn, the Fed’s vice chairman.

Most central bankers don’t think zero is actually low enough to deal with weak economic activity, high unemployment, low confidence and a still fragile banking system. In the standard calculation, current conditions are so dire that people and companies should be paid to spend money. But zero rates are better than nothing, so to speak. Central banks are at least not doing anything to impede lending.

That’s the theory. But with the financial system still in post-traumatic shock, it’s not certain that the ultra-low policy rates are getting through the banks and into the real economy. Business lending remains weak.

Even if the aggressively low rates are helping activity, the gains come with losses. The financial infrastructure is being undermined. Central bankers think almost entirely about the incentive to borrow, but non-zero rates also create an incentive to save. When the policy rate is zero, so is the incentive. A prolonged period of nearly free official money makes it hard to recreate a much needed culture of savings in the US and UK.

Also, whether or not the transmission from policy rate to real economy is working well, financial markets seem to respond all too strongly. Commodity prices have risen sharply and the dollar and pound – the currencies of the central banks most committed to ultra-cheap money – are dropping.

Ultra-low rates were justified, despite the risks, when GDP and trade were in freefall and banks were gasping for support. But conditions are now more stable. The risks are starting to outweigh the rewards. Central bankers should put rate increases back on the agenda.

http://www.telegraph.co.uk/finance/breakingviewscom/6325982/Time-for-rate-increases-is-approaching.html