Policy Notes No.6
05 December 2014
Why Raising Rates May Speed the Recovery
Criticisms of the Federal Reserve’s “unconventional” monetary policy response to the Great Recession have been of two types. On the one hand, the tripling in the size of the Fed’s balance sheet has led to forecasts of rampant inflation in the belief that the massive increase in excess reserves might be spent on goods and services. And even worse, this would represent an attempt by government to inflate away its high levels of debt created to support the solvency of financial institutions after the September 2008 collapse of asset prices. On the other hand, it is argued that the near-zero short-term interest rate policy and measures to flatten the yield curve (quantitative easing plus "Operation Twist") distort the allocation and pricing in the credit and capital markets and will underwrite another asset price bubble, even as deflation prevails in product markets.
Both lines of criticism have led to calls for a return to a more conventional policy stance, and yet there is widespread agreement that this would have a negative impact on the economy, at least in the short–term. However, since the analyses behind both lines of criticism are mistaken, it is probable that the analyses of the impact of the risks of return to more normal policies are also in error.