Fed makes needed rate increase

David MoonBlog

I’m not accustomed to praising the Federal Reserve, but this past week the Fed avoided a tempting opportunity to make (another) major mistake. In an effort to head off worsening inflation, the nation’s central bank raised interest rates a half a percent at its May 4 meeting. After learning that the economy contracted in the first quarter and is already halfway to an official recession, I expected the Fed governors to weasel out and raise rates a more modest – and almost meaningless – quarter-point.

They did they right thing.

Federal Reserve has painted itself into a corner. Because interest rates are artificially low, it will require a significant increase to have any effect on consumer prices. But a significant increase will weaken the economy even further, likely placing the U.S. officially in a recession only a couple months before this fall’s mid-term elections.

The legally stated policy objectives of the Federal Reserve Open Market Committee are to promote maximum employment, stable prices and moderate long-term interest rates. The Fed has long abandoned even pretending to pursue moderate long-term interest rates. And we already have almost full employment.

That leaves the Fed needing to pursue stable prices – that is, fight inflation. When faced with inflation, the Fed usually raises interest rates to cool economic growth and slow increases in consumer prices.

After its March meeting, the Fed appeared poised to raise rates a half-point at its May 4 meeting, but given the already weak state of the economy, that large of an increase would almost certainly tip the economy into a recession. But any smaller increase would have essentially no effect on decreasing inflation.

The Fed made the harder decision to stick with its inflation-fighting rate increase. Good for them.

Even after this week, the Fed does not have good choices, but it can blame only itself. In the decade following the mortgage meltdown of 2008, the U.S. economy grew by 50 percent. Rather than using this period of strong economic growth to allow interest rates to drift upward to provide a cushion above inflation, the Federal Reserve continued its emergency quantitative easing program, pumping another $2 trillion into the economy and artificially depressing rates long after the emergency was over. Now that the economy needs a well-executed nudge, the Fed has little room to maneuver.

Policymakers are seldom good at nudges. Anything government-related seems to live by the rule, “if one aspirin is good for a headache, 30 pounds of aspirin must be great.” Seldom has a politician discovered a useful policy that couldn’t be ruinous if used to exaggeration.

And don’t let the Fed’s label of independence convince you otherwise: the Federal Reserve Board governors are politicians.

David Moon is president of Moon Capital Management. A version of this piece originally appeared in the USA TODAY NETWORK.