For some time now the Fed has been hinting that it will moderate its interventions--monetizing government debt by printing money to buy government bonds and now quantitative easing by printing money to buy corporate bonds--in order to drive down the interest rate to unprecedented low levels. The Keynesian theory behind these interventions is that lower interest rates will spur lending, which in turn will spur spending. In the Keynesian mindset spending is all important--not saving, not being frugal, not living within one's own means--no, spend, spend, spend. The Keynesians running all the world's banks firmly believe that it is their duty that spending not diminish one cent, even if this means going massively into debt. Keynes himself famously said that government should borrow money to pay people to dig holes in the ground and then pay them again to fill them back up.
To Austrian school economist like myself, this is childish, shallow, and ultimately dangerous thinking. Austrians understand that economic prosperity depends first of all upon savings, not spending. Savings is funneled by the capital markets into productive, wealth generating enterprises. Gratuitous spending is simply consumption. Now, there is nothing wrong with consumption...as long as one has actually produced something to be consumed. Printed money is not the same as capital accumulation. Or, as Austrian school economist Frank Shostak explains, goods and services are the "means" of exchange and money is merely the "medium" of exchange. Expanding the means of exchange through increased production--which requires increased capital, which itself requires increased savings--is a hallmark of a prosperous society. Increasing the medium of exchange out of thin air, as is current central bank policy, is the hallmark of a declining society that has decided to eat its seed corn.
Of course, the central bankers and their political friends are terrified of a recession that undoubtedly would follow an increase in interest rates. What our monetary and political masters do not understand is that the recession is both necessary and inevitable. It is necessary in order to end capital consumption and wealth destroying enterprises. Furthermore, it is inevitable in that the structure of production has been so skewed toward capital consumption that production is threatened. We are living on both borrowed money (at home and abroad), and the accumulated capital of previous generations. This one time spending spree WILL end. The longer we try to prop up spending with borrowed and printed money, the worse will be the reckoning when it does come.
So, how far should the Fed go in raising interest rates? There is no answer for this question. The Fed must end its monetary interventions and allow the free market to determine the interest rate that balances savings with loan demand. The last time the free market was allow to work, in the era of Fed Chairman Paul Volcker, the prime rate went to over 20%. This was very hard on both business and workers, but inflation was cured and the American economy shed itself of wealth destroying enterprises and became the economic powerhouse of the world once again. The same thing can happen, if only our monetary master get out of the way.