After last week's hike in the discount rate, a number of Fed officials have said that the fed funds rate will not be increased for a long time. It seems they are trying a bit too hard to convince skeptical investors.
The latest salvo came from Janet Yellen, San Francisco Federal Reserve President. Yellen said interest rates must be kept "extraordinarily low" because economic growth will fall short of its potential through 2011. Yellen and others believe interest rate hikes are not yet necessary, especially since the Fed is planning to take other measures to reduce liquidity. For example, it will stop buying mortgage-backed securities (which could result in another round of declines in housing sales and prices), and it may start reducing the size of its balance sheet by selling some of its assets, thus draining money from the economy.
While such tightening measures can be effective, an increase in the fed funds rate sends a much stronger signal. In my previous post, I argued that a modest increase in the fed funds rate should be welcome news. I continue to believe the Fed will raise the fed funds rate sooner than it is currently telegraphing. If it fails to do so, investors should worry that the economy is sicker than the Fed would like us to believe.
