Mark Calabria

To help the economy, the Federal Reserve should begin raising rates immediately and bring its preferred policy rate, the federal funds, to a more neutral stance. The Fed’s current rate policies have not delivered economic growth or employment and should be abandoned in favor of policies that would.

The theory behind the Fed’s current rate policy is that lower rates increase the demand for borrowing, which should fuel both credit-driven spending and investment. This however, only examines one side of the market: demand. For credit to expand, lenders must be willing to lend at those rates as well, but current rates barely cover a lender’s inflation risk without also covering the risk of not being repaid.

It was a housing boom and bust that contributed primarily to the recession and financial crisis. While housing prices have begun to recover, credit for less-than-prime borrowers is still limited, leaving about a fifth of the market on the sidelines.

Looking at mortgage rates offers some explanation. Today, 30-year fixed rates are just over 4.2 percent. With inflation expectations running around 3 percent, that leaves the lender only 1 percent to cover credit losses and any profits. With just over 2 percent of prime mortgages still in foreclosure, and assuming a 50 percent recovery rate, it becomes obvious that anything but sterling credit is expected to be a money loser for banks.

So why don’t banks just charge more? Because so-called consumer protection laws would kick those mortgages into the “high cost” category, which brings considerable legal risk. Letting rates rise would greatly increase the supply of mortgage credit, helping to fuel home sales and eventually home construction.

Low rates are often defended as “putting money in the consumers’ pocket” but that couldn’t be further from the truth. It simply transfers money from one set of consumers to another. The approximately $400 billion annual decline in consumer interest payments since 2008 has been exactly off-set by the approximately $400 billion annual decline in household interest income. Lower rates simply benefit one set of households at the expense of another. The net impact on spending will likely approximate zero.

Mark Calabria

Mark A. Calabria, is director of financial regulation studies at the Cato Institute.

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