Submitted by Scott Baker, Sep 10, 2007 11:05

The days when the Fed needed to try and guess which way the market would head in the future and act accordingly are long over. Now, the Fed should just keep the funds rate at .25-.5 basis points above inflation at all times, and stick to accurately measuring inflation. The Fed is nearly always behind the curve, ratcheting up rates going into the new Millemium, just as the Y2K/Tech bubble was bursting, racing to cut rates, and creating the housing bubble, just as the economy was already turning around, racing back upslope to raise rates from 2003-2006 and then holding, even as conditions were rotting from inside due to credit excesses - which the Fed allowed through too easy margin requirements. (Personally, I don't care if some hedge funds blow up and their managers wind up living in cardboard boxes on the street, but why should they be able to borrow money without limit and bring dow the markets for the rest of us who invest more conservatively? Whatever happened to pudence?) The Fed needs to restrict excess borrowing at every level it can and get out of the which-way-is-the-economy-heading guessing game.

Besides, as I've said on my blog, http://newthinking.blogspot.com/2005/06/interest-rate-hikes-cause-inflation.html, radical as this sounds,

Interest Rate Hikes *cause* Inflation

Interest Rate Hikes are a cost of doing business that, while a buisiness is still growing, can and are passed on to the consumer in the form of higher prices, which by definition, equals inflation.

When does the Fed raise interest rates? When the economy is expanding, right? Right. And when the economy is expanding it is because the businesses that drive it are expanding, meaning they have some pricing power. Now, business might prefer not to raise prices, just as they certainly would prefer not to borrow money to expand at a higher cost, but when the economy is still strong, and when their competitors are subject to the same federal policy, they can and do borrow money at a higher cost, and can and will pass that higher cost on to the consumer if they think they can get away with it. Business has a lot less foresight to the condition of the economy a year away than most people think and is driven more by quarter to quarter results, so they will expand when they need to, even at higher borrowing costs. This leads, in turn, to higher prices.

Higher prices = Inflation.

Since the economy is very elastic, it can absorb these higher costs for a while, before the cumulative effect becomes overwhelming, causing a rebellion by the consumer and a consequent sharp slowdown in spending and borrowing. This causes businesses to sell less, reduce output, layoff workers, contract and all the known effects of a contractionary - or in the worst case, recessionary - cycle.

The Fed gets us into Recessions, every time it overshoots, which is nearly always.

Solution: Let growth, competition and innovation reduce the pressure to increase prices when demand exceeds supply.
In today's very fast moving modern economy, there is little to fear from short term (1-3 months) price inflation. Expensive goods and services open the way to new ways of doing things - cheaper. The Fed almost never needs to raise rates significantly above the rate of inflation, and should spend its time measuring inflation accurately. Measuring inflation accurately is especially challenging in a service economy where even profound innovations become rapidly commoditized - e.g. computers and software, mutual funds, energy production etc.

There is always a new innovative way of doing things that is better, cheaper and more efficient. By raising rates onerously - that is, beyond the rate of inflation - the Fed takes money primarilly away from those who need it most; the startups, inventors and entrepreneurs who invigorate the economy, and not from the established, high cash flow, traditional companies, who have deep reserves and do not need to borrow as heavilly in percentage terms. In other words, by charging excessive interest rates, the Fed discourages innovation and encourages the status quo, lack of competition, and stagnation (stagflation too).

Let innovation drive down inflation, not punishing interest rates.

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