A Solution to Avoid Bubbles By the Fed

A recent report stated the U.S. labor market is still weak, which could lead the Federal Reserve to consider another round of unconventional monetary policy action. This, however, would be a step in the wrong direction. My argument is based on the clear distortions that the Fed is creating in the loanable funds market — the market where individuals, firms, and the government come together as lenders and borrowers of funds to determine an agreed upon rate of interest.

Instead of throwing more bank reserves in to the financial sector, the Fed should begin to raise their target for the federal funds rate. A higher interest rate would allow savers to gain a higher rate of return on their savings and would incentivize firms to invest as they anticipate higher borrowing costs. If the Federal Reserve sold off a portion of the increase in their assets, which are now $2.75 trillion, specifically assets with lower quality (mortgage backed securities) and less liquidity (long-term treasuries), then the possibility of asset bubbles would be reduced.

Thomas Hoenig, the Federal Reserve president of Kansas City, agrees that rates should rise, as is evident when he states that "I do think we have to get off of zero if we want to avoid repeating some of the mistakes of the past with a very easy credit environment."

I certainly agree with him, as many of these mistakes have directly led to asset bubbles in the past. Therefore, higher interest rates should be one of the primary solutions in stimulating the economy.

The supply side of the loanable funds markets is comprised of the available funds that banks lend out. A fed funds rate target of 0-0.25% leaves banks with less incentive to lend to the public because the cost of lending to the public is much higher than parking their excess of bank reserves (now $1.45 trillion) at the Fed and gaining 0.25% for them. With more than 13 million people unemployed, many banks believe that the risks of lending to individuals and firms during a period of deleveraging and increased government intervention are too high.

On the other side of the market and in the current environment, demand for loanable funds is not efficient. Interest rates have been at historical lows since December 2008, which is when the federal funds rate target was set to the range of 0-0.25%. Federal Reserve Chairman Ben Bernanke's recent press conference explained that the FOMC (Federal Open Market Committee) is not likely to change this rate for at least two more meetings from now. Since the group only meets every six weeks, it is likely that the rate will stay the same at least for the next three months.

This extended period of a lower fed funds rate affects firms’ decisions to borrow and invest; it does not encourage them to make timely investments because it may be more beneficial to wait until the last possible moment. Many firms are likely replenishing their revenues after the economic decline, and are very cautious about when to make investments. The ability to learn from past mistakes and become more efficient in a free market environment will increase economic growth, but distorting the loanable funds market by artificially keeping rates low will not allow growth to occur.

Changing the Federal Reserve’s statement to an expectation of raising the funds rate would encourage firms to borrow and invest earlier. If firms expect higher rates, those debating whether to get a loan or not will go to the bank sooner, as their future costs would rise. 

Because government manipulation created a lack of equilibrium in the market for loanable funds, there will be sluggish growth and inflated asset markets across the economy. We all want the economy to improve and for jobs to be created, but there is not always a consensus on how. The U.S. government lost its chance to provide economic growth and stability. Instead, we should now try other means to solve the economic crisis.

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