Should the Fed Raise the Federal Funds Rate?
• In May, well-known hedge fund manager David Einhorn wrote an article in the Huffington Post entitled "The Fed's Jelly Donut Policy." In the article he compared the Federal Reserve's easy monetary policy to eating jelly donuts: at first the donuts taste good but the more a person eats the worse he or she feels. His point was that too much of a good thing can be harmful.i Traditional economic theory states that an increase in the money supply causes an increase in aggregate demand because consumers feel wealthier since they have more money but prices have remained the same (again in the short term). There is an exception to this theory though: the Keynesian Liquidity Trap. In the Keynesian Liquidity Trap interest rates are already close to zero, and risk-averse households are reluctant to spend. When the money supply increases households choose to hoard rather than spend the money. Under this scenario increases in the money supply do not help the economy at all since the velocity – how often money changes hands to purchase goods – of money has declined.
• Near zero interest rates also hurt savers. For the approximately 10,000 baby boomers who are retiring each day for the next 20 years, they are faced with a choice with how to invest their money: invest in low yielding savings accounts and bonds or invest in the stock market. After having experienced both the dot-com bubble and crash and the housing bubble and crash over the past decade, these retirees and soon-to-be-retirees might hesitate before deciding to put money in the stock market again. With the Fed having all but guaranteed that it would be purchasing bonds over the next 3 years, many savers prefer the safety of these securities. Why risk losing money in stocks when you could choose the comfort of Treasuries? This causes the retiree a problem though: if he or she does not want to purchase stocks and instead wants to keep all of his or her money in Treasuries earning 2-3 percent, he or she is giving up the potential of obtaining the higher rate of return historically offered by stocks. What can that individual do to make up for not achieving a higher rate of return? Save more!
• Finally, I would like to reiterate a conclusion that I heard from J.P. Morgan's head economist, David Kelly. If the Fed states that it will not change rates for the next few years, what incentive is there for consumers and business to refinance their mortgages or invest in equipment, respectively, in the short term? There isn't. Why do something now when you can wait to see how the economy is in the next couple of years?
iEinhorn, David. The Fed’s Jelly Donut Policy. 5 May 2012. The Huffington Post. 23 October 2012. <http://www.huffingtonpost.com/david-einhorn/fed-interest-rates_b_1472509.html.>
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