The Federal Reserve has made the first move in its process of restoring the federal funds interest rate to its benchmark value, by increasing it to a level that will neither stimulate nor restrain the nation’s economy. Many players in the financial market have lauded this approach, but some are warning that this could instead, be a dangerous miscalculation.
The move follows in the footsteps of a similar action taken when rates were incrementally restored from 2004 to 2006. Some analysts argue that that gradual increase set the stage for what turned out to be one of the worst financial crises in recent history and started the recession in 2008. They now warn that the similar scenario might follow if the same approach is taken.
Not only is the Fed planning on using the same strategy, but the language that has been used makes it pretty clear that the increases will be even more gradual than the ones from ten years ago. Analysts are already debating if the rates will be going by 25 basis points twice or three times a year, making the return to the usual 3 percent nearly four years away.
However, looking at the previous experience, gradual normalization will allow for excess liquidity that leaves monetary markets open to increased risk and borrowing excesses. With an even longer normalization being a near certainty, those risks become a serious cause for concern. Considering that there are already some warning signs of troubles in several markets, including high-yield and emerging-market debt, this anxiety will only increase.
The only way to break this vicious circle is to shorten the time that it takes to bring the rates back to their standard range, reducing the chances of a risk buildup. If the Fed takes on the markets sooner rather than later, the odds of the markets taking on the economy diminishes, creating a potentially more stable environment.