Gathering Economic Strength Will Force Tough Decisions

When it comes to raising rates, it's now or never. Or later. Or soon. What is Fed Chairman Ben Bernanke to do?

Uh-oh, more good news on the economy. Factory orders grew 1.1 percent in November, more than twice the forecasted gain of 0.5 percent, according to Bloomberg. That gain is going to add urgency to an already-heated debate about when to halt the 16-month-old economic stimulus. It's a tough call. End the stimulus too soon and there's a good chance that the economy will sink back into recession. End it too late and risk igniting a destructive bout of inflation.

Some economists are pushing the administration to keep the stimulus in place until it is quite clear that the economy can grow on its own strength. Paul Krugman warns that the economy is still weak, thanks to a terrible job market. He says the administration must avoid repeating the errors of 1937, when policymakers took the economy off life support and prolonged the Great Depression. This is essentially the Main Street view—one that puts jobs and income at the center of the economic universe, even if that means accepting a higher risk of inflation. "The odds are that any good economic news you hear in the near future will be a blip, not an indication that we’re on our way to sustained recovery. But will policymakers misinterpret the news and repeat the mistakes of 1937? Actually, they already are," Krugman says. He argues that the stimulus will have its peak effect around the middle of this year and fade, even as unemployment remains high. "Congress should have enacted a second round of stimulus months ago, when it became clear that the slump was going to be deeper and longer than originally expected. But nothing was done—and the illusory good numbers we’re about to see will probably head off any further possibility of action," he warns. The Fed already has halted purchase of long-term Treasury debt, and it is expected to halt purchase of mortgage debt this spring—way too soon, Krugman warns. His skepticism about the economy was probably bolstered Tuesday by a separate report that showed a plunge in pending home sales for November.

The view from Wall Street, where fighting inflation is critical to preserving the value of fixed-income investments and in driving capital into the stock market, argues that the recovery is real, or that it is probably real, and that the Fed should exercise caution by starting to raise interest rates now. Fed Chairman Ben Bernanke is already talking about a fiscal exit strategy, and the bond market has priced three interest rate increases for this year into the market, according to bond management company PIMCO. And Stephen Roach, the chairman of Morgan Stanley Asia, told Bloomberg on Tuesday that Bernanke should raise rates now if he believes the economy is as strong as he says it is. "There is never an easy time to do it. The longer they wait, the greater the chance they sow the seeds for the next bubble. So I’m in favor of an early exit strategy," Roach said.

The stakes for the economy couldn't be much higher. And there's no way to know for sure whether it is best to end the stimulus now or to wait. The answer comes down to whether the administration wants to err in the favor of Wall Street or Main Street. My guess: It will split the difference by leaving rates where they are as long as it can, but it will move sooner to end other elements of the stimulus, such as the purchase of mortgage-backed securities, which is designed to keep rates low. Those purchases don't grab headlines in the same way that interest rates do, but they can have just as much impact, if not more.