Economist recommends raising rates to 2% to stimulate lending

Once again, another economist telling us that we should raise the benchmark Federal Funds rate to 2%.  Steve Hanke is an economics Professor at Johns Hopkins and a Senior Fellow at the Cato. 

I would recommend 1.5%, but that is just a guess.  Stay tuned as we have a more substantive piece coming up about where the interest rates should really be.  Via Cato:
In the monetary sphere, the Fed has, in a standard Keynesian manner, flooded the economy with high-powered base money since the onset of the crisis in late 2008. But, with the crisis, the money multiplier collapsed and has remained depressed. In consequence, broad money measures, such as M2, have barely budged during the post-crisis period and the economy has continued to disappoint. 

To understand why, in the Fed's sea of liquidity, the economy is being held back by a credit crunch, we have to focus on the workings of the loan markets. Retail bank lending involves making risky forward commitments. A line of credit to a corporate client, for example, represents such a commitment. The willingness of a bank to make such forward commitments depends, to a large extent, on a well-functioning interbank market — a market operating without counterparty risks and with positive interest rates. With the availability of such a market, even illiquid (but solvent) banks can make forward commitments (loans) to their clients because they can cover their commitments by bidding for funds in the wholesale interbank market.

At present, the major problem facing the interbank market is the zero interest-rate trap. In a world in which the risk-free Fed funds rate is close to zero, banks with excess reserves are reluctant to part with them for virtually no yield in the interbank market. Accordingly, the interbank market has dried up — thanks to the Fed's zero interest-rate policy — and, with that, banks have been unwilling to scale up their forward loan commitments.

In short, the Fed's zero interest-rate policy has created a credit crunch that is holding back the economy. The only way out of this trap is for the Fed to raise the Fed funds rate to, say, two percent.


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