Fed starts to go in the right direction

The Federal Reserve raised short-term interest rates on Wednesday, the stock market cheered, and the bond markets shrugged. We’re slowly getting back to normal.

Interest rates have remained too low for too long, forcing investors into risky assets. People who preferred to save their money rather than spend it were punished by low interest rates on government bonds and cash deposits. Pension funds and retirees suffered the most.

An overnight interest rate of 1 percent is not going to improve matters much, but after years of maddening timidity, Janet Yellen is finally leading the Fed in the right direction. If we can get to 1.5 percent, or maybe 2 percent, by the end of the year, the financial markets will reach something close to normalcy.

For those who don’t remember what that looks like, the Fed Funds Rate was 5 percent as recently as May 2006, when central bankers recognized that the housing markets were out of control. That’s because when money is cheap to borrow, people behave recklessly and borrow more than they should.

The Great Recession of 2008 provides evidence of why higher interest rates are needed. By the time the Fed acted in 2006 to make borrowing more expensive, the housing bubble was already too big. Home

prices plummeted in 2007, and we all know what happened next.

Former Fed Chairman Ben Bernanke tried to stanch the economic hemorrhaging by dropping rates to effectively zero in December 2008. And there they stayed until Yellen, his replacement, raised them in December and then again on Wednesday.

On the left, pundits decry the move as too early because the percentage of Americans in the workforce has not returned to pre-2007 levels, even if the official unemployment rate is very low. Critics on the right will complain that by raising rates, the Fed will hurt the Trump recovery by making loans more expensive.

Just like journalists, central bankers know they are doing their job when both sides are angry with them.

My big concern for the past two years has been what the Fed will do when this period of growth ends and we face another recession. Bernanke could ease the pain of the 2008 recession by lowering rates from 5.25 percent in September 2007 to zero in December 2008.

Yellen was at 0.5 percent until December. She had no ammunition to kickstart the economy before then, and frankly, still doesn’t have much now. Negative interest rates have not proved very effective in Germany or Japan.

The setting of interest rates is known as monetary policy, the control of the amount of money in an economy. But there is an equally important sibling known as fiscal policy, which is the government spending and tax policies set by Congress.

An underappreciated reason for the slow economic recovery is that Congress cut spending at the same time that individuals and businesses did. Yellen had to keep interest rates low to make up for the lack of spending.

President Donald Trump has promised a fiscal policy that will flood the economy with cash. He plans to cut taxes and boost government spending. Such a rapid increase in spending will trigger inflation if the Fed doesn’t discourage borrowing by raising interest rates.

But if Congress doesn’t approve the big tax cuts and the big spending that Trump has promised, then the economy won’t see the flood of cash. If there is an unexpected geopolitical event, such as another 9/11-style attack, people and companies will stop spending and suck cash out of the economy.

In either case, having a fed funds rate that is high enough to cut will help. But be sure of one thing: If the economy doesn’t go the way Trump wants, he will blame Yellen for raising interest rates. Even if she did the right thing.