Fed bets it will avoid past central bank errors

LONDON - The Federal Reserve is poised to raise interest rates Wednesday for the first time since 2006. It may not take that long to know whether its decision was correct.

History is filled with cases, from the Fed in the 1930s to the European Central Bank in 2011, when central banks raised rates prematurely, sometimes with dire consequences. Raising rates or otherwise tightening credit too soon can slow borrowing, jolt confidence, and choke growth.

When the global financial system started buckling in 2007, central banks cut rates to fight the worst economic catastrophe since the 1930s. As the crisis escalated in late 2008, many rates were slashed to record lows. The Fed cut its benchmark rate to near zero.

Mindful of the risks of higher rates and of the U.S. economy's lingering weaknesses, some economists have suggested that the Fed could wait a bit longer before raising rates, especially with inflation still low amid slumping oil and commodity prices.

In a survey of top academic economists, the University of Chicago found that while 48 percent favored a rate hike, 36 percent felt the Fed should hold off.

Andrew Levin of Dartmouth College is among those who think the Fed would be acting too soon.

"The economy is not that close to normal yet," Levin says.

Levin notes, too, that while the unemployment rate is a low 5 percent, millions without jobs have given up looking for one. Levin says employers would have to add 200,000 jobs a month for at least another year to restore the job market's health.

For any central bank, the hardest task is to continually straddle a delicate balance.

Keeping rates too low for too long can inflate asset bubbles as investors seek returns that are higher - but riskier - than returns on government debt. Low rates can also weaken the ability of central banks to combat a new crisis or recession.

But central bankers must take care not to increase rates too soon. Since the global financial crisis, several central banks, from Israel's to New Zealand's, have raised rates, only to have to reverse course soon after.

Chair Janet Yellen summed it up in a speech Dec. 2. Yellen said delaying a first increase too long might later compel the Fed to raise rates faster than it would like.

"An abrupt tightening would risk disrupting financial markets and perhaps even inadvertently push the economy into recession," she said. "Holding the federal funds rate at its current level for too long could also encourage excessive risk-taking and thus undermine financial stability."

Here are some examples when history suggests central banks here and abroad should have waited longer to tighten credit.

The Fed's 1937 error. In 1936-37, during the Great Depression era, the Fed sought to normalize its policies by increasing the amount of money banks had to hold as reserves. Many blame that decision, along with a tougher budgetary stance from the U.S. government, for helping to prolong the Depression. The economy fell back into a brutal recession in which around 2.5 million Americans lost jobs.

By 1938, President Franklin D. Roosevelt reverted to the expansionist policies associated with the New Deal that he had been implementing since 1933. And the Fed rescinded the increased reserve requirement. The economy then enjoyed a spectacular recovery.

Japan's lost decades. Ben Bernanke, the Fed chairman during the 2008 crisis, was a keen student of Japan's experience after the bursting of a stock and housing bubble in 1990. A quarter-century later, Japan still confronts the repercussions of that shock, notably deflation, or falling prices.

In August 2000, barely a year after the Bank of Japan adopted a zero-rate policy, it raised rates for the first time in a decade. It justified that move by noting that confidence was returning and prices were rising. But a few months later, the central bank was compelled to cut rates again as Japan's economy slid back into recession and prices fell again.

Japan's experience reflects the risks of raising rates when inflation is negligible, as it is in the United States.