Don’t Look for the Fed to Raise Rates Soon

The Federal Reserve has injected about $1 trillion of liquidity into the credit markets over the past seven months and slashed the federal funds rate now to 2 percent.

Those moves, particularly the opening of the discount window to securities firms for the first time in about 70 years, appear to have averted a complete meltdown of the financial system.

The inflation threat is real, but don't look for interest rate hikes soon.

"The Fed is making the same mistake as in the 1970s, shifting all its weight to trying to prevent a recession," Allan Meltzer, one of the country's pre-eminent Fed watchers over the last 40 years, tells MoneyNews.

"The Fed is sacrificing the possibility of future inflation," says Meltzer, now a visiting scholar at the American Enterprise Institute. "I'm sure they're telling themselves they will respond in time to the inflation."

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Meltzer doesn't see that as likely.

"Congress, Wall Street and Main Street don't like increases in interest rates," he notes, and one could add the White House to that group.

"There is a lot of pressure against rate hikes," Meltzer says. "Fed policymakers haven't shown themselves capable of responding to the pressure by saying they can't do that."

To be sure, a substantial number of experts disagree with Meltzer. If the Fed hadn't eased policy and bailed out Bear Stearns, they argue, the financial system could have suffered a catastrophic recession.

And while the economy appears to be in the early stage of recession, the Fed's easing, along with fiscal stimulus, should eventually spark a rebound.

Some also argue that the swoon of short-term rates in the Treasury market will spur increased bond issuance by the government, worsening the country's debt burden.

The latter argument doesn't carry much weight. Fiscal policy determines the amount of government borrowing, not monetary policy.

Moreover, much of the government's borrowing comes at the long end of the Treasury market, where rates haven't declined nearly as much as at the short-end.

"The sooner the Fed eases rates the better for the budget," says Roger Kubarych, chief U.S. economist of Unicredit HVB, Europe's second largest bank.

That's because "the government will end up with much more borrowing in a recession," as tax receipts decline and spending needs rise, he tells MoneyNews. So the Fed needs to ease quickly to jumpstart the economy.

In addition, while the Fed's easing is undeniably inflationary, prices were rising well before the Fed started loosening its reins, especially commodities. "There has been inflation all along," Kubarych points out.

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