What’s the Best Way to Change Interest Rates?

This question came to me as I was reading this CNN/Money piece discussing possible Fed action on interest rates this year. The article basically poses the question of whether interest rates will have to rise a lot or a little over this year.

But the title of the article raises another interesting question. Suppose that Greenspan thinks that interest rates will need to be at least, say, 2.5% a year from now. Currently the Fed Funds rate is at 1%. Should he plan to get to that 2.5% goal by enacting six quarter-point increases in interest rates, coming every month or two? Or instead, would it be better to plan to do it in just 2 or 3 large movements of .5% or even .75%? For example, he could move them up .75% this summer while simultaneously announcing that there will be no more increases for the rest of the year.

As I see it, the main benefit of the incremental approach is that it allows for caution and adaptation to continual economic developments, and may therefore reduce the chances of overshooting the economy’s ideal interest rate. The problem that I have with this argument is that it is typically estimated to take at least 6 months for an interest rate change to have measurable effects on the economy. So it’s not clear to me that the incremental approach gains you increased accuracy in getting to the appropriate interest rate; if you’re raising rates every month or two, then with each further increase you’re reacting based on the effect of an increase that you made 3 moves ago – you haven’t yet seen the effect of the previous couple of increases on the economy. So actually, I wonder if this could make it more likely that you overshoot the economy’s ideal interest rate?

The main benefits of the “bang and stop” approach – a relatively sharp rise in interest rates now followed by no further increases for a considerable time (I’m open to a better name than “bang and stop”, if you have one) – are that it provides greater certainty to businesses and consumers as they try to predict the course of interest rates over coming months; and that the long time of no further policy action gives the Fed enough time to better evaluate the effect of its first interest rate increase on the economy before it becomes necessary to have another rate increase.

The more I think about it, the less I like the incremental approach. If you think that interest rates need to rise (and I’m not quite convinced that they do, yet), then get it over and done with and move on.