MacroScope

Why the Fed shouldn’t raise rates to discipline Congress

October 1, 2012

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Federal Reserve Chairman Ben Bernanke has been trying for some time to fend off critics of his bond-buying policies who argue the central bank is making it easier for the federal government to run deficits. In remarks to the Economic Club of Indiana on Monday, he seems to have found a useful way to help illustrate his point.

It follows logically that those who say the Fed is abetting profligate governments might want to see higher interest rates that would discourage excess federal borrowing. Bernanke pursues this line of thinking to its natural conclusions – and is very uncomfortable with the results:

I sometimes hear the complaint that the Federal Reserve is enabling bad fiscal policy by keeping interest rates very low and thereby making it cheaper for the federal government to borrow. I find this argument unpersuasive. The responsibility for fiscal policy lies squarely with the Administration and the Congress. At the Federal Reserve, we implement policy to promote maximum employment and price stability, as the law under which we operate requires. Using monetary policy to try to influence the political debate on the budget would be highly inappropriate.

For what it’s worth, I think the strategy would also likely be ineffective: Suppose, notwithstanding our legal mandate, the Federal Reserve were to raise interest rates for the purpose of making it more expensive for the government to borrow. Such an action would substantially increase the deficit, not only because of higher interest rates, but also because the weaker recovery that would result from premature monetary tightening would further widen the gap between spending and revenues. Would such a step lead to better fiscal outcomes? It seems likely that a significant widening of the deficit – which would make the needed fiscal actions even more difficult and painful – would worsen rather than improve the prospects for a comprehensive fiscal solution.

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Too true. Yet, this is exactly what happens to consumers. If someone is late on a credit card payrment, the rates often double or triple and the credit limit can be reduced, making it much harder for the person too manage any cash flow issues. It’s interesting that the exact strategy which is deemed bad for economic growth is the same strategy upon which the banking industry bases its risk management of debtors.

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