The chairman of the Federal Reserve is stuck between a rock and a hard place—well, more like a house and a gas tank. How to escape? Mr. Bernanke, raise interest rates now.
In order to the save bank balance sheets that he never cleared of toxic mortgage assets, Ben Bernanke's near-zero interest rate policy and dollar- printing programs were an attempt to create a so-called wealth effect. "Lower mortgage rates will make housing more affordable and allow more homeowners to refinance," Mr. Bernanke wrote in a Washington Post op-ed last November. "Lower corporate bond rates will encourage investment. And higher stock prices will boost consumer wealth and help increase confidence, which can also spur spending."
In other words, the Fed is manipulating the stock market. And it has been on a tear, up 19% since Mr. Bernanke's Jackson Hole speech last August outlining a second round of quantitative easing.
Unfortunately, when you print dollars, you debase the currency—and it shows up in higher oil prices, already rising well before the rebellions in Egypt and Libya. Copper and wheat and food are also seeing increases. For that matter, just about everything is rising except home prices. The Case-Shiller home price index dropped 2.4% in December.
What Mr. Bernanke's dollar printing has given to consumers in a supposed wealth effect, it has taken away in the cost of living.
Worse, the bond market is spooked and long-term interest rates have spiked. The 10-year Treasury has gone to 3.28% from 2.5% since Mr. Bernanke chatted up QE2 last August. When spreads are widening between short-term and long-term rates, it usually means that banks don't want to lend. Lenders see runaway commodity prices and rightly fear that current long-term rates will rise with inflation, putting any loans made today underwater quickly. Banks see near-zero short-term rates and dollar printing stretching out to the horizon, and they no longer believe long-term rates are going lower, so they sit. Businesses too are waiting to hire until the economy is back to normal. Zero interest rates are not normal.
Mr. Bernanke has to change their view. He could persist on his present course and keep trying to juice the stock market to induce wealth, but consumers will still be dragged down by $80 fill-ups at the pump, and the economy will continue sideways.
It's all counterintuitive, but it will work. Ending quantitative easing and raising short-term rates will surely cause the stock market to crater. 1,000 points? 2,000? Who knows? But a selloff will ensue. Does that mean a negative wealth effect? I doubt it. Who really thought they were wealthier at Dow 12,000 versus Dow 10,000?
Some banks will sputter, and maybe even fail, even the big boys. But they've already had two years since the end-of-the-world sell-off in March 2009 to get their acts together, and many can now pay dividends. Hopefully the FDIC is ready to dive in and remove the remaining toxic mortgage assets of any failing banks, along with their managements, and then refloat the institutions. This contingency should be well mapped out by now with the Orwellian-named "Orderly Liquidation Authority" in the Dodd-Frank law.
But along with a likely lower stock market and failing banks will be several positive effects that will finally kick-start the economy. Oil and wheat and commodities will see a 20%-30% drop in price as speculators run for the hills. This will be a de facto tax cut for consumers. Hiring should restart when businesses see normal short-term rates, most likely 2%.
Similarly, the dollar, suddenly backed by rising interest rates, will start to rise. Unlike those foolish enough to believe that a lower dollar is the path to growth, a higher dollar will lower prices across the board, especially at Wal-Mart—shoes, shirts and sugar. Even better, the companies that are leading the economy, such as Apple and EMC, will benefit from lower costs for memory and storage, as will Google and Facebook stocking their data centers. This price cut on productivity tools will be a good thing for the economy and the real wealth effect.
And even better, despite rising costs from higher short-term rates, surviving banks will lose their fear of rising long-term rates and will start lowering banking spreads, signaling their willingness to lend and fund a real recovery.
The municipal and state debt crisis is going to happen no matter where short-term rates end up. Spending cuts and higher tax receipts from an expanding economy are their only salvation. Raising rates may be the only way to get there.