By Roberto Rigobon, Society of Sloan Fellows Professor of Management and Professor of Applied Economics at MIT Sloan; a research associate of the National Bureau of Economic Research; and a visiting professor at IESA.
Nearly seven years ago the Federal Reserve put its benchmark interest rate close to zero as a way to bolster the economy and has not raised that rate since. For the past several months, the Fed has struggled to decide when it will dictate an increase, and it appears the announcement is imminent this week. While this increase is actually more of a "normalization," a December tightening of rates will have lasting consequences.
First, let's address why leaving interest rates too low for too long is a bad idea: primarily because low interest rates can lead to bad behavior. Banks might take too much risk--after all, almost every investment looks good when the financing cost is close to zero. Individuals are also more likely to borrow too much and save too little--hence increasing leverage ratios. What harm is a loan when the interest rate is negligible?
By moving interest rate targets up or down, the Fed attempts to achieve maximum employment, stable prices and stable economic growth. The Fed will tighten interest rates (or increase rates) to stave off inflation. Conversely, the Fed will ease (or decrease rates) to spur economic growth. Raising the rates is good for the economy, but only after the economy has consolidated and is in good health. Which, right now, it is.
So if the economy is strong, why is it taking so long for the Fed to decide? To put it bluntly, they have bad data.