U.S. Fed May Wait Too Long to Raise Rates, Hanke Says

By Shamim Adam

Sept. 29 (Bloomberg) -- The U.S. Federal Reserve may keep its benchmark interest rate at a record low for “too long,” increasing pressure on the dollar to weaken, said Steve Hanke, a professor at Johns Hopkins University.

Fed Chairman Ben S. Bernanke and other policy makers may hold off increasing rates until after the mid-term Congressional elections in November 2010, as inflation stays within the central bank’s target range, Hanke said in an interview in Kuala Lumpur late yesterday. The U.S. economy will probably slow once rates are increased, resulting in a W-shaped recovery, he said.

Fed policy makers indicated last week for the first time in more than a year that the economy is accelerating, while recommitting to keep their key rate “exceptionally low” for an “extended period.” The majority of policy makers consider a longer-run inflation rate of about 2 percent to be consistent with the Fed’s mandates for full employment and price stability.

“If you look at what the Fed is saying now, and you look at Bernanke’s inflation-targeting mentality, they won’t do much as long as the headline inflation rate stays in that zone of zero to 2 percent,” Hanke said. “It’s conceivable they’ll wait too long and they’ll probably keep as loose as they can before the elections. 2011 would really be way too late.”

The U.S. faces the possibility of becoming “trapped” in a situation with low levels of inflation and interest rates near zero, Fed Bank of St. Louis President James Bullard said Sept. 25. He doesn’t vote on rates this year.

The W Scenario

The Fed, in a statement after its Sept. 23 policy-setting meeting, said “inflation will remain subdued for some time.” Consumer prices fell 1.5 percent in the year ended in August.

“The economy is coming back, and as it starts coming back, we’re going to have inflation in the picture,” said Hanke, professor of applied economics at the university in Baltimore. “As we have more and more inflation, ultimately, the Fed will probably start fighting it and when they do, it’s going to tip us into another slump. That’s the W scenario.”

The U.S. needs to adopt a policy for a “strong and stable dollar” to ensure sustained economic growth and attract investment, Steve Forbes, chief executive officer of Forbes Inc., said in an interview in Kuala Lumpur yesterday. The trade- weighted Dollar Index has fallen 11 percent since President Barack Obama’s inauguration in January, in part because of a budget deficit projected to rise to $1.6 trillion this year as the government increases spending to boost the economy.

‘Complete Disaster’

The dollar’s decline will increase commodity prices, contributing to inflationary pressures, Hanke said. A stronger dollar limits investors’ need for physical assets such as commodities to hedge against inflation.

“This is a complete disaster because the Fed wants to keep inflation up between zero and 2 percent but as long as they are in that zone, they just don’t care what happens to the dollar,” he said. “If you have a weak dollar, you have all sorts of problems and knock-on effects related to it.”

Hanke is recommending investors go “long” the Indonesian rupiah and the Australian dollar versus the U.S. currency, calling them “good” carry trades. A long position is a bet that a currency will strengthen. The carry trade uses funds in countries with lower borrowing costs to invest in those with higher rates, allowing investors to pocket the difference.

He also suggests going long on the euro against the pound after Bank of England Governor Mervyn King said last week that the decline in the sterling’s value will help to rebalance the U.K. economy by shifting resources into exports.

Avoid Yuan Gain

“The pound will stay under more pressure,” Hanke said. He is in the Malaysian capital for the three-day Forbes Global CEO Conference, which started yesterday.

Hanke said China should avoid allowing its currency to strengthen, calling a resumption of gains “bad policy” and “destabilizing.”

The yuan appreciation “will just do the same thing that it did the last time,” Hanke said. “The speculative flows will start coming in and they’ll have more problems than they’ll know what to do with. They’ll have to accumulate even more reserves and get more China-bashing from the U.S. It’s very destabilizing if they start doing that.”

To contact the reporter on this story: Shamim Adam in Kuala Lumpur at sadam2@bloomberg.net