Plunge on Wall Street? Fed should stay the course.

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    Federal Reserve Vice Chair Janet Yellen stands after testifying during a confirmation hearing on her nomination to be the next Fed chairman in Washington this past November. Despite a nearly 500-point drop on the Dow this week, caused in part by worries about the Fed's tapering of stimulus measures, the central bank should stay the course.
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In the wake of this week’s plunge on Wall Street and the recent tepid jobs report, it is easy to conclude that our economy is not as strong as we thought and to second guess the Federal Reserve’s recent decision to taper its bond-buying program.  Yet the stock market and jobs report are only parts of the picture. Our economy is rising, consumer confidence is up, and the housing market continues to recover.  In other words, our economy is definitely improving, just not that evenly.

Taking this into account, the Fed should stay its course, for a taper and the resulting increase in interest rates will actually help our economic recovery rather than hinder it. The reason is that cheap money is a double-edged sword.  While on one hand, it encourages the deployment of capital for investment and growth, on the other, it fuels excessive borrowing, reckless spending, and the creation of asset bubbles.

After the frenetic rise and fall of the subprime mortgage market and the economic meltdown that followed it, Americans are painfully familiar with bubbles. Unfortunately, their desire to spend today often outweighs their sense of fiscal responsibility for the future, and so the lessons of the past are being conveniently forgotten.

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Consumer borrowing is trending upwards, rising by $12.8 billion in November to a national total of $3.09 trillion.  Auto and student loans are up 8.2 percent from a year ago and credit card debt, although still below its pre-2008 level, is at a three-year high.  Disturbingly too, issuances of collateralized loan obligations (one of the infamous securitization vehicles that exacerbated the real estate bubble) surged to $86 billion last year and will likely remain high despite restrictions imposed by the Volcker Rule, and banks are increasingly making auto loans to subprime borrowers as delinquencies fall, possibly fostering another asset bubble and bringing to mind the events leading up to the mortgage crisis.

The longer the Fed’s easy money policy stays in place, the greater the risk of a new bubble (or multiple bubbles, for that matter) taking over our markets, which is why a sudden big correction on Wall Street should not surprise us.  Action from the Fed is not only prudent but also urgent.

Since the end of 2008, the Fed has targeted a Fed Funds rate of 0-0.25 percent and the prime interest rate (which affects consumer loans) has remained fixed at 3.25 percent after dropping from an average of 5 percent in 2008. As the Fed begins its gradual taper, these rates will slowly edge upwards, affecting not just the borrowing costs for banks and businesses but for consumers as well, which should slow down borrowing across the board. Moreover, with inflation in check and business activity on a natural upswing, a gradual increase in rates should be able to prevent the economy from overheating without derailing the recovery. 

The important thing to remember is that growth fueled by cheap debt is not sustainable in the long term and the longer the free ride lasts, the harder it will be to correct course.  Higher interest rates may seem like a burden, but they are vital to the enduring health of our economy.

– Political and business commentator Sanjay Sanghoee has worked at leading investment banks Lazard Freres and Dresdner, as well as at multibillion-dollar hedge fund Ramius. His opinion pieces have appeared in Time, Bloomberg Businessweek, Fortune, and Huffington Post, and he has appeared on CNBC’s ‘Closing Bell’, TheStreet.com, and HuffPost Live.

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