The Federal Open Market Committee in its latest statement September 23 announced that it was considering ways to reverse the unprecedented torrent of liquidity it has pumped into the US financial system, but that interest rates will remain near zero for a prolonged period. Apart from the question of when the Fed should move, that has got the order wrong. Removing “quantitative easing” will be a perilous process, which should be undertaken slowly and with great care. Pushing up interest rates substantially is an urgent necessity, which should be done today.

Neither raising interest rates nor removing quantitative easing is imminent, yet a substantial policy move in the direction of monetary tightening should be made. Zero interest rates remove all incentive to save, so we see that the September US savings rate was back down to 3%, closer to the zero at which it languished in 2004-07 than to the 8-10% to which it needs to rise in order for the US economy to achieve long-term stability. It’s not surprising people aren’t saving; they have no incentive to do so. The value of savings is currently eroded little by little by inflation, while the modest returns available on debt instruments are taxable at up to 40% on nominal income. An environment of very little saving, with all spare cash going into short-term speculation, is the inevitable result of this.

As for inflation, it has been quiescent so far, as year-ago comparisons have been flattered by the sky-high energy and commodity prices of summer 2008. However those comparisons are dropping out of price indices in the next few months and commodity and energy prices have recently been strong, so inflation should visibly accelerate. The price index for personal consumption expenditures, Fed chairman Ben Bernanke’s favorite because it so well behaved, rose 0.3% in August and has been rising at an annual rate of 3.7% over the last three months.

According to the latest Federal Open Market Committee meeting, quantitative easing will continue at least until the end of the year. For one thing, the Fed has not yet bought all the $1.2 trillion of mortgage-backed debt it intends to buy – it is at $692 billion according to its latest report, so has over $500 billion to go. With such a large additional buyer artificially in the mortgage-backed bond market, and the government guaranteeing $1 trillion of mortgages through the Federal Housing Administration with down-payments as low as 3%, it is little wonder that house prices have bounced and the construction sector’s activity is up by 8% in the last month. This is not however a healthy housing market recovery; it is propped up by artificially easy money, both in terms of rate and availability. Hence at some point, when the money is withdrawn, the housing market is likely to fall back, with damaging effect on the nation’s banking system.

The difficulty of removing quantitative easing is illustrated by the fact that the two worst depressions in US history were both caused by liquidity shortages. In 1837, the de-chartering of the Second Bank of the United States removed the primary instrument, Second Bank bills, by which inter-regional trade had been financed. In 1836 a Mississippi merchant could pay for New England textiles with a Second Bank bill, and give the seller full value. The following year, unless he had gold (scarce then) he could give the seller only Mississippi bank paper, which traded in Boston and New York at a 30-40% discount.

In 1930-32 the closure of the Bank of United States, a major New York retail bank, caused a withdrawal of deposits from the banking system and a cascade of bank failures that similarly devastated systemic liquidity. In both cases, depressions ensued, the two worst in US history.

In 1837-43, the problem was solved by a gradual expansion in soundly-based state banks, which had been suppressed by the Second Bank’s existence. Nevertheless it was not until the 1849 California gold discoveries that liquidity was fully restored. In 1930-41, the Great Depression persisted for a decade, being exacerbated by numerous other policy mistakes, before being lifted by the beginnings of wartime economic expansion.

It should be noted that in both cases, interest rates were not the problem. In 1837, the speculation of 1836 had caused interest rates to rise. However the crash of May 1837 caused a sharp reversal, and thereafter throughout the period of depression short-term and long-term interest rates remained relatively low. In 1930-32, the Fed kept nominal short-term interest rates around 1-2%, very low by historical standards, while long-term Treasury rates declined. However in both cases the sudden drain of liquidity caused sharp price deflation, with prices falling around 20% in 1837-41 and even more in 1930-33.

At present, there are two countervailing factors affecting liquidity. On the one hand, the securitization market for home mortgages and other consumer obligations is nowhere near back to normal, and may indeed never get back to “normal”. Furthermore, bank capital ratios are currently being increased to meet the desires of newly conservative regulators. Both these factors tend to drain liquidity from the market. On the other hand, the high volume of liquidity available worldwide, caused by excessively lax monetary policy in most countries, has caused sharp run-ups in stock prices, commodity prices and especially long-dated US Treasury bond prices, which are far above the level implied by the current 2-3% inflation and 10% of GDP budget deficit. The 10-year US Treasury bond yields only 3.25%, giving holders almost no real yield, at a time when the US dollar is weak, inflation rising and the US government’s financing demands unprecedented.

In an ideal world, liquidity withdrawal would deflate stock, commodity and bond markets, pushing real interest rates closer to a normal level, while leaving the availability of finance through the banking system for small business relatively relaxed, as befitting a deep recession. In reality, given the gigantic budget deficits and eldritch incipient recovery in the housing market, it is likely to do the opposite, squeezing small business before it corrects stock, commodity and bond prices.

Hence the Fed should continue planning for liquidity withdrawal, but attempt it only very cautiously.

On the other hand, raising interest rates sharply, perhaps to a 2% Federal Funds rate in the initial step but with the announced intention of moving rapidly towards 5% (higher if inflation takes off in the interim), while maintaining high liquidity, would appear to offer only benefits. Since interest rates paid by small business borrowers are far above those paid by the government, an increase in Federal Funds rates and Treasury bond yields will have minimal effect on small businesses, provided liquidity remains high. Small business loans will still offer the highest interest margins to lenders, so if liquidity remains available and lenders are not concerned about their own funding, they will be made.

On the other hand, a sharp increase in interest rates would kneecap stock, bond and commodity markets, aborting the rapidly inflating bubble that is threatening to produce yet another orgy of resource misallocation. In the stock market, casinos would no longer be able to bail themselves out of bankruptcy through IPOs. Internationally, a drop in oil prices would shove Messrs. Chavez, Ahmadinejad and Putin at least partly back in their boxes, while a fall in the gold price would short-circuit inflationary psychology before it really takes off.

Higher short-term interest rates would give U.S savers at least a zero real after-tax risk-free return on their money, thus ending the odious Keynesian “euthanasia of the rentier” that Bernanke and his predecessor Alan Greenspan have been undertaking since 1995.

Most important, a really frightening crisis in the Treasury bond market would bang the heads of Congress and the Obama administration against the wall, and force them to start getting the budget deficit under control.

Once higher interest rates have deflated the various bubbles, pushed the housing market down to a sustainable bottom and forced the government to rein in the budget deficit, liquidity can be gradually removed from the market, as the government’s financing needs and the bubbles’ demands on liquidity will no longer be so excessive. In that way, over a 2-3 year period, the Fed could return the US financial system to a healthy state. It is however essential for it to remove the market pressure from abnormally low interest rates and abnormally high funding requirements BEFORE removing the liquidity. The other way around won’t work.

Knowing the Bernanke Fed, it will doubtless do precisely the reverse of what this column recommends, beginning to withdraw liquidity vigorously at an early date, while keeping interest rates at their present abominably low levels for far too long. In that case, the Fed will deserve the hyperinflationary depression it will almost certainly get.

It’s only a pity that the rest of us, innocent of wrong-doing, should have to live through it.

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(The Bear’s Lair is a weekly column that is intended to appear each Monday, an appropriately gloomy day of the week. Its rationale is that the proportion of “sell” recommendations put out by Wall Street houses remains far below that of “buy” recommendations. Accordingly, investors have an excess of positive information and very little negative information. The column thus takes the ursine view of life and the market, in the hope that it may be usefully different from what investors see elsewhere.)