NEW YORK (CNN/Money) - Let's see: the job market's still sluggish, wage growth is slowing and inflation is all but dead, despite the lowest short-term interest rates in more than 40 years -- so what should the Fed do next?
Jack up interest rates, according to one of Wall Street's most respected economists.
Morgan Stanley chief economist Stephen Roach, long among the most bearish observers of the U.S. economy, on Monday reiterated a recent plea to Federal Reserve Chairman Alan Greenspan that he made last month: raise short-term rates. Now. By a lot.
"Based on the Federal Reserve's own assessment of recent and prospective vigor of U.S. economic growth, it is now time to reload the monetary cannon," Roach wrote in a note to clients posted on the Morgan Stanley Web site.
"A failure to do so ... is a recipe for a never-ending outbreak of asset bubbles. Largely for that reason, I have urged the Fed to raise the federal funds rate immediately to 3 percent."
The central bank's target for the fed funds rate, a key overnight bank lending rate that affects banks' prime lending rates, stands at 1 percent, a level not seen consistently since the early 1960s.
Pushing that rate up two full percentage points in one fell swoop would be the Fed's most drastic move since the late 1970s and early '80s, when the central bank was battling runaway inflation.
Such a move would be unprecedented in Greenspan's 16-year tenure at the Fed. The only time on Greenspan's watch the Fed has raised rates that much, it took the central bank's policy-makers most of a full year, 1994, to do so.
What's more, such a rate hike would probably cause another recession, by stifling borrowing and slamming financial markets.
But Roach says such pain is preferable to the alternative: another dangerous bubble in asset prices, which he believes the Fed's low-rate policy is only encouraging.
The popping of the last asset-price bubble -- namely, in stocks -- led to the 2001 recession and has been followed by abnormally sluggish job growth for a recovery.
If another asset-price bubble were to build and pop -- and Roach worries that real-estate markets, stock prices and Treasury prices are in danger of over-inflating now -- the effects would be much more painful, leaving the United States looking like Japan in the 1990s, in a post-bubble deflationary spiral, with the Fed helpless to intervene, he argues.
"In my view, the perils of another burst asset bubble far outweigh the costs of another recession," Roach wrote. "With only 100 basis points left in its policy arsenal, the Fed is running a huge risk if it lets another asset bubble form." One hundred basis points equals one percentage point.
Some other economists, generally among the more optimistic, have been calling on the Fed to raise rates but for a different reason -- namely, that good old-fashioned, garden-variety inflation is coming down the pike.
"I believe the Fed is holding rates excessively low today -- current monetary policy is inflationary," said Brian Wesbury, chief economist at Griffin, Kubik Stephens & Thompson in Chicago. He added that he believed Roach's proposed immediate 200 basis-point hike would devastate the economy, but "they could scratch out 200 basis points over six months and have minimal effect."
Most other economists, however, doubt that raising rates by any amount will be a viable option for the Fed any time soon.
"For the Fed to hike rates now would be the equivalent of a doctor prematurely declaring a patient at full health, discharging them from the hospital and then forcing them to run a mile," said Ethan Harris, chief economist at Lehman Brothers.
What asset bubble?
Harris said forecasting models suggest that a two-point hike in the fed funds rate would cut economic growth in half, push unemployment higher and immediately increase the risk of the very deflation that Roach hopes to avoid. Deflation is a vicious cycle of falling demand and falling prices that cripples economic growth.
And, despite a raft of criticism about his handling of the late-1990s stock bubble, Greenspan still says the Fed's job is not to monkey with asset prices, but to make sure the economy stays strong, no matter what asset prices do.
"The Fed's number one concern is the lack of any meaningful job creation in this recovery," said former Fed economist Wayne Ayers, now chief economist at Fleet Boston Financial.
The government reported Friday that payrolls grew by just 21,000 jobs in February -- statistically barely any growth at all -- causing some forecasters to say the Fed won't even think about raising rates until 2005.
What's more, many economists doubt new asset bubbles are forming.
Stock valuations may look a little bubbly, but they're still nowhere near the overheated levels of the late 1990s. Lots of people worry about soaring home prices, but economists are unified in their belief that the market's on solid footing, with supply at a reasonable level and demand justified by super-low mortgage rates.
And while Treasury bond prices have stayed stubbornly high, keeping bond market rates very low, there are many reasons for this -- including low inflation and a campaign by some foreign central banks to buy U.S. bonds to boost the dollar.
"There are other real issues we need to look into before we begin posing solutions to problems that don't exist," said former Fed economist Robert Brusca, now chief economist at Native American Securities in New York.
But Roach warns that, by the time the Fed gets around to raising rates -- probably not until after the November election, according to many forecasts -- the inflation picture could look a lot different, and by then it could be too late.
If it wants to avoid the pain of raising interest rates, he said, the Fed could take other measures to avoid asset bubbles, including raising margin lending requirements and requirements for real estate lending.
"America cannot afford to let its central bank be stymied by problems of its own making," Roach wrote. "This week marks the fourth anniversary of Nasdaq 5,000. Have we learned anything?"