The Cure for the Economy's Ills: Higher Rates?

After two years of historically-low interest rates and a painfully anemic economic recovery, some in the financial community are throwing their weight behind a novel approach to injecting some confidence into the economy: raising interest rates.

They believe slowly hiking rates would send a clear message to the world that while the U.S. economy is still not operating on all cylinders, it’s also not about to crash into the ditch.

Of course, the concept of raising rates in this difficult environment stands in direct opposition to nearly everything that most modern economists believe in. However, it is receiving some support from some who are skeptical of the Federal Reserve’s easy-money strategy and especially from those who blame the Fed for economy’s current ills.

“Those outside of the world of professional academic economics are already starting to see the Fed is an emperor with no clothes and the losers of the failed policy outnumber the winners,” said Walter Zimmerman, senior vice president of United-ICAP.

To be sure, there is virtually no chance the Fed will do a 180 and remove the markets’ easy-money punch bowl. And there are very real chances such a move would backfire and do more harm than good. Still, it’s interesting to note such a move is even being debated by some in the financial markets.

Cheerleading Economic Sentiment

Proponents of raising interest rates point to a number of factors to bolster their case.

They say that every time Fed chief Ben Bernanke pledges to leave interest rates at their current 0% to 0.25% range for an unknown period of time, it reinforces the message the U.S. economy stinks. By saying the economy needs these low rates, it makes businesses scared to hire, invest in new endeavors or lend money.

“The heart of it is sending a signal that the economy is okay. It’s not great. We know unemployment at this level is too high,” said Rick Roberts, who recently retired as a partner at First Quadrants, a Pasadena, Calif.-based investment management boutique.

Of course, simply raising interest rates won’t instantly make the U.S. economy better and is unlikely to mask its current ills.

“The sentiment is negative for a reason: the economy just isn’t any good,” said Gus Faucher, director of macroeconomics at Moody’s Analytics. “I don’t buy that argument at all.”

Still, it’s clear the current low rates have failed to live up to the goal of boosting lending enough to satisfy demand. According to a May 2011 survey from the Atlanta Fed, only 41% of small firms had their overall financing needs met in full.

Likewise, mortgage rates are already sitting at historically low levels. Last week Freddie Mac said the average rate for a 30-year fixed loan plunged to 3.94% -- the lowest level since 1971. Analysts don’t believe they will get much lower and even if they do, they’re unlikely to lure in buyers.

The debate over raising rates underscores frustration with traditional economic models as well as the lack of a playbook for today’s unique environment.

“There is no academic research that puts an economy in our current situation at the current unemployment in a global marketplace where the economies are so leveraged,” said Roberts. “I’m suggesting we possibly do something different in order to spur confidence.”

Do Low Rates Encourage Bubbles?

Other backers of raising interest rates point to a history of low rates helping to inflate asset bubbles that do major damage to the economy. They say that when rates are historically low, money needs to chase higher returns in other asset classes, such as stocks and real estate.

Zimmerman faults easy-money policies as the cause of bubbles in Internet stocks a decade ago, the stock market and commodity complex until 2007 and the overheated housing market.

Each time one of those asset bubbles burst, it took a chunk out of consumer sentiment, which remains on a downtrend. Last month the University of Michigan said the outlook component of its consumer confidence index plummeted to its lowest level since 1980.

“They’re not going to get their confidence back until we’ve had a period of low to no financial volatility,” said Zimmerman. “You have to strangle the source of financial volatility, which the data indicate is low interest rates. Our view is banks and consumers would benefit from higher interest rates because it would subdue financial volatility.”

At the same time, returning to a period of incrementally higher rates would bring a sense of normalcy back into the marketplace.

“That’s the environment we’re all used to. I think it would give comfort to the market and to investors,” said Bill Bartmann, CEO of Bartmann Enterprises and author of Bailout Riches. “Doing nothing has put the investment community into a pause mode. I absolutely believe the giant consensus, the overwhelming consensus, would be: about damn time.”

One of the biggest beneficiaries of higher rates would clearly be Americans who are struggling to save their money. The Fed’s current policy has ensured cash sitting in savings accounts has earned virtually no interest.

“The biggest cheerleaders of [raising rates] would have to be savers,” said Greg McBride, senior financial analyst at “This interest rate environment has completely thrown savers and retirees under the bus.”

Kenneth Kamen, president of Mercadien Asset Management, echoed this point, saying, “There is a huge swatch of the economy – mainly baby boomers and older people – that are getting no interest on their savings. It’s conspired to create the opposite of a wealth effect.”

Of course, McBride warns higher rates would do damage to many other consumers and businesses that have variable rate debt. This includes everything from adjustable-rate mortgages to credit cards and home equity lines of credit.

Even Zimmerman concedes this point, though he says it would give consumers a new incentive to deleverage.

Hiking Rates Could Backfire

McBride also warned higher rates could lower home prices by sapping already-anemic demand.

Mortgage rates are “at unbelievably low levels,” said McBride. “Pushing them lower is not going to push someone to buy a house if they’re worried about job security. But pushing rates higher is not going to help the housing market either.”

These concerns are among the chief reasons why most people oppose raising interest rates.

“It would make the economy worse, not better. That’s the standard economic theory, and I buy that,” said Faucher, who expressed lingering concern about the threat of deflation.

Kamen said he believes that while the Fed’s current strategy may not inspire much confidence and may be unpopular, it seems to be the only choice.

“Until we see a real demand increase for money, keeping money on sale is logic,” he said. “I think rates down here make a lot of sense.”

If the Fed were to hike rates, it would likely destroy its own credibility. The central bank – and Bernanke – have stakes their reputations on the low-rate strategy and promised the markets to hold to it.

Faucher said such a move would lead most investors to question Bernanke’s “sanity.” He said, “It would be a 180 degree turn without any change in the data.”

Peter Kenny, managing director at Knight Capital, said he was intrigued by the idea of raising rates, which he called “counterintuitive,” but is fearful about what it would do to the country’s enormous debt load.

By raising interest rates, the U.S. government would have to pay more to finance those enormous obligations, creating a potentially scary situation.

“Rising rates means it’s more expensive to carry debt. Even at current estimates, it is an intolerable debt load,” said Kenny.

He added, “I think it’s a novel idea, but in real terms, I don’t think it makes a lot of sense.”