The Punch Bowl Economy

William McChesney Martin was the ninth chairman of the U.S. Federal Reserve Board from 1951 until 1970. He is perhaps most famous for his October 1955 quip to the effect that the role of the Federal Reserve is "to take away the punch bowl just when the party gets going." In other words, don't overstimulate the economy through ill-advised monetary policy.

Investors are repeatedly warned that they cannot -- and should not -- try to time the market when it comes to buying and selling stocks. At the same time, if Mr. Martin is correct, then the Fed's role is, essentially, to time the market -- or at least to help shape it through its monetary-policy decisions.

If the Fed holds interest rates too high for too long, it can slow economic growth and trigger a recession. It did precisely this, intentionally and to good effect, in the early 1980s to tame exceedingly high inflation rates. If the Fed holds interest rates too low for too long, it can trigger asset bubbles (as investors pile into assets offering higher returns) and inflation.

Not too hot. Not too cold. Like Goldilocks ... just right.

For more than six years, the Federal Reserve's Federal Funds Rate (the interest rate it charges for overnight short-term loans to its member banks) has been slightly above zero. When you factor in the modest inflation during this period, the real interest rate at times has been negative. Think of negative interest rates in this manner: you are actually paying your bank to hold your money for you. Why would anyone do this? Because of a climate of overall investment uncertainty coupled with a desire for safety. If you hold a negative interest rate mortgage, you are, in essence, being paid to borrow the money.

People living on fixed incomes or savings are clearly hurt in such a low-interest-rate environment. On the other hand, those with ready cash can become big winners. With low returns on bonds, investors will roam the world to find higher returns, and, in doing so, may bid up assets such as real estate and equities. Query whether, for example, the current New York City real estate market or the U.S. stock market are now overvalued as a result of this extended, almost unprecedented zero-interest-rate policy.

Clearly the Fed cannot keep interest rates at zero forever. Just when it should begin to raise interest rates has been the subject of intense speculation for close to a year. Chairman Janet Yellen's every utterance is now parsed for some inkling of when the Fed will make its move.

But here is perhaps a deeper question to ponder. After more than six years of zero interest rates, why isn't the American economy on a tear? Admittedly (and fortunately) the American economy is doing far better than that of the European Union. At the same time, we've also had multi-trillion dollar stimulus programs under presidents George W. Bush and Barack Obama; multi-trillion dollar deficit spending by the federal government; incentives to car buyers and first-time home buyers; plus the addition of roughly $4.5 trillion to the Fed's balance sheet after three rounds of Quantitative Easing (e.g., the Fed's decision to inject capital into the economy through the purchase of government and mortgage-backed securities). The economy should be booming.

Mix these effects together, and you've got one helluva punch bowl -- perhaps the most heavily "spiked" punch bowl in the nation's history. When the party ends -- and it will, soon -- it will be curious to see whether the economy has suffered any serious long-term structural damage as a result of prolonged zero interest rates.

Typically, the Federal Funds Rate has been closer to 4.5 percent. Refinancing our more that $18 trillion national debt at 4.5 percent (or higher) will add billions of dollars in interest payments to the annual federal budget. These new, higher interest costs will further crowd out domestic discretionary spending. Likewise, interest rates on home purchases, automobiles, and other durable goods will rise. Will consumers, who have been cautious spenders in recent years with low interest rates, suddenly borrow and spend more when interest rates rise? Unlikely. Rising interest rates will serve to strengthen an already strong U.S. dollar. This occurrence will mean good news for U.S. importers and Americans touring Europe, but it will be bad news for U.S. exporters and foreign tourism in New York, San Francisco, and Disneyland.

From the Fed's current perspective, a "Goldilocks" outcome would be unemployment between 5 and 5.2 percent by late this year and 2 percent inflation by 2017. Such a smooth glide path would be wonderful, but it is a wild guess as to the future impact of rising interest rates on economic growth. It is, after all, economic growth that has been sluggish throughout this recovery from the Great Recession, and without robust economic growth, all other projections are accompanied by uncertainty.

The Fed should probably have acted sooner. For those who sip too long at a heavily spiked punch bowl, there is frequently a long and painful morning-after headache.

Charles Kolb served as Deputy Assistant to the President for Domestic Policy from 1990-1992 in the George H.W. Bush White House. He was president of the French-American Foundation -- United States from 2012-2014 and president of the Committee for Economic Development from 1997-2012.