The fed seems intent on raising interest rates as a part of the broader unwinding of the economic recovery stimulus that has been in place. A look at undoing the four trillion in quantitative easing also needs to take place. Before looking at the merits and impact unwinding QE will have, it’s important to look at the mechanics as it will come up in the discussion.

When the fed injected money into the economy they did so via overnight lending. Essentially, they “borrowed” overnight from their primary banks that are used to effectuate the fed moves. The interest from this overnight borrowing is the money that was injected into the economy. To undo QE the reverse process occurs. The fed “loans” to the primary banks overnight, and the interest the primary banks repay is what is used to take money out of the economy. It’s slightly more complicated than the described process, but that’s the basic framework.

When undoing the economic stimulus both interest rates as well reversing QE aspects need to be addressed. The global economy seems to be unsettled with further decline more likely than recovery. Prudence calls for undoing the past stimulus measures so the fed is able to act if necessary should the global slow down spread to our economy. Interest rates need to return to some level the fed is comfortable with that balances the negative impact higher interest rates have on the economy against the need to have some mechanism to stimulate the economy in case of a future economic slowdown. Although the dollar is doing well, another round of QE should weaken the dollar so an unwinding of QE needs to occur to lessen the impact on the dollar should another round of QE be initiated.

When undoing the past stimulus the two areas to consider are the impact of disposable income and second order effects. Disposable income is the usual method of keeping the economy afloat in economic downturns. While businesses may reduce capital expenditures people still must eat, babies diapers must be changed, etc. This is why stocks for staples (Gerber and Johnson and Johnson for example) suffer less in a recession.

Raising interest rates and undoing QE have markedly different impacts when looking at discretionary spending versus second order effects. Raising interest rates has a direct, almost immediate reduction on disposable income. Anything with a variable rate goes up, so the next month’s budget reflects the reduction in disposable income. While raising the interest rate from zero to two per cent isn’t a great impact on disposable income in individual instances the aggregate effect will show up in the economy.

The second order effects are much less significant than undoing QE. As the spread between deposit and borrowing interest rates spread (the most likely outcome of increasing interest rates) banks will start to realize a profit for not lending. This will make them more financially sound and create a capacity to do more lending medium term as their capitalization improves over time. The lessened rate of lending will have an overall drag on the economy, but demand will build and eventually the pent up demand will be acted upon when there is the future stimulus package.

The lesser rate of borrowing serves to delay economic activity more than it does to reduce the economic activity. As such, it adds a boost to the effects of a future stimulus lessening the overall need for stimulus when the need arises as the fed’s action to stimulate the economy has a greater initial impact.

While raising interest rates discourages borrowing tightening the money supply (undoing QE) discourages lending. The mechanics are such that the bank capitalization becomes lower and the ability to loan is reduced. The big benefit (other than the ability to reverse course on a day’s notice) is that the dollar is strengthened. The dollar is strengthened because monetary tightening reduces supply in the face of a relatively stable demand driving the value of the dollar higher. This has a whole host of positive second order impacts.

Two of the major impacts are the dollar becomes a safe haven investment in the current economic uncertainty, and since the price of oil is tied to the dollar the price of oil continues to drop. Let’s look at each of these in turn. Making the dollar a safe haven investment causes an inflow of funds to the treasury as the dollar is purchased for investment purposes. One option is to simply not borrow as much reducing the rate of debt accumulation since the balance sheet will not be as negative.

A more prudent option is to use the increased revenue to service some of the debt that is currently outstanding. Early servicing doesn’t eliminate the maturity value of the outstanding debt, but it does allow it to come off the books. This becomes important to protect the country from a possible economic attack by countries that hold debt that aren’t exactly friendly.

The dollar would be significantly weakened should countries at least somewhat unfriendly decided to sell their outstanding debt holdings. China owns around 10{997ab4c1e65fa660c64e6dfea23d436a73c89d6254ad3ae72f887cf583448986} of the US outstanding debt. A move to sell in mass quantities would cause noticeable harm to the economy. While it’s imprudent for China to sell given the amount of economic consumption we engage in, should their economy continue to fall there comes a point where the move looks appealing as it would create a glut of immediate inflow into their treasury.

Using the increased revenue from the strong dollar to service China’s debt holdings serves to benefit both countries. We have the debt off the book, and China has an inflow of revenue to use in helping to prop up their sinking economy. At some point the investment in the dollar will be redeemed, but by clearing debt service payments from the balance sheet the redemption will be easier to meet negating the negative impact the redemption has.

Driving the price of oil lower also serves to promote our national interest. Yes, the local economy will hurt, but we may be past the point of no return for the negative economic impact on the local economy. With the price of oil projected to stay low for an extended period a new wave of economic failure on a national level is a significant possibility.

Should this occur, the global economy will be weakened and a ripple effect will spread at least to the regions where the failures occur. Driving the price of oil down now accelerates this occurrence, and the economic damage can be contained within the current economic malaise rather than a separate event that happens in the future and acts as a weight or the global economy when it happens.

Lower oil prices also hurt our geopolitical enemies. Russia is burning through capital reserves, and their budget projection was for an average $40/barrel price. Lower oil causes greater reserve depletion. Monetary tightening causing a drop in oil prices takes place over time and becomes a negotiating tool for the next administration when dealing with Russia.

Our enemies in the Middle East are also harmed. Iran is set to benefit with the lifting of sanctions, but dropping the price of oil limits the benefit they receive from lifting the sanctions. ISIS uses oil as a cash cow. Lower oil prices serve our interest in both instances.

A combination of harming our geopolitical enemies and accelerating the simmering economic collapse of countries that are dependent on oil as their economic driver only serves to strengthen the US economy as the dollar becomes an even more attractive safety investment. The ability to mitigate the global downturn is then increased via the servicing debt as described above and while the overall pain intensity is increased, the duration is shortened causing long term economic stability. The greater good calls for both interest rate hikes and undoing QE.