Why it’s time to silence the calls for higher rates

June 2, 2011, 5:40 PM UTC

FORTUNE — Two-thirds of Americans believe the U.S. is still in a recession, according to a recent poll by Hamilton Place Strategies, even though we’re reaching the two-year anniversary of its official end. So when is the right time to raise interest rates?

The debate has been evolving for months among central bankers struggling to tame inflationary pressures and keep their economies growing. This isn’t much of a surprise, especially in the U.S. and Europe, where consumer and business spending has seen better days. In April, the European Central Bank raised rates for the first time since 2008 and it’s signaled that it may raise them further in July. In the U.S., despite some resistance, Federal Reserve chief Ben Bernanke has so far steadfastly avoided it.

But lately the call for rate hikes has grown louder. The Organization for Economic Cooperation and Development last week urged several economies, including the U.S., to start raising rates before the end of this year, as deflation risks fade and rising prices loom. The Paris-based think tank suggested the Fed raise rates to 1.0% in the second part of the year from the current 0.25%.

“We are in a phase of strongish recovery with some good signs that [the recovery] is becoming less policy driven and more self-sustained,” Pier Carlo Padoan, the OECD’s chief economist, told the Financial Times last week.

The recommendation adds to a growing chorus of Fed officials saying it’s time to raise rates, even while many analysts expect GDP growth this year to be too weak to put much of a dent in the stubbornly high unemployment rate.

Minneapolis Federal Reserve Bank president Narayana Kocherlakota, one of five regional Fed presidents with a vote this year on monetary policy, told The Wall Street Journal last month that it’s “certainly possible” that the Fed could raise short-term interest rates by more than half a percentage point late this year if underlying inflation rises as he anticipates. Kocherlakota joins two other regional Fed presidents with votes – Charles Plosser of Philadelphia and Richard Fisher of Dallas – who favor rate hikes.

Raising rates to 1% might not seem like much, but anything much more than that can be perceived as somewhat unnerving given a still-fragile and very uncertain U.S. recovery. To be sure, there are a few reasons to start raising rates. For one, it could lessen the chances of steeper rate increases later on that could potentially disrupt markets. At this point, it’s also easy to argue that monetary policy has done as much to boost the economy as can be reasonably expected. It’s not as if record-low rates have solved much of the problems of the U.S. economy — cheap borrowing costs haven’t done much to spur many home purchases or compel companies to hire much. Ultimately, interest rates can’t stay at near zero forever and will eventually need to rise.

The question is timing, and whether central bankers should put inflationary pressures ahead of weak growth. Adam Posen, an external member of the Bank of England’s monetary policy committee, says raising rates now would surely make the economy worse off.

“When you tighten fiscal policy significantly after a major financial crisis, both history and mainstream economics would tell you to expect what we have now: no growth in broad money or credit, persistently high interest spreads for small businesses and households, flat or contracting private consumption and retail sales, a dearth of construction and declining real wages – all only partially offset by some expansion in exports,” Posen wrote in a recent op-ed in the Financial Times.

Low interest rate policies have helped lead to the rapid rise in asset prices. Although it’s unsustainable, the demand from these rapidly rising prices has helped the soft recovery, says Nobel Laurete Michael Spence. “Bottom line is that raising interest rates now, unless the increases are very  gradual, threatens to abort the fragile recovery,” says Spence, author of The Next Convergence: The Future of Economic Growth in a Multispeed World.

In addition to the U.S., the OECD suggested the Bank of England follow the path of the European Central Bank and raise rates in the coming months. But the U.K. has also been resistant as its economy slogs through another quarter. GDP rose 0.5% during the first three months this year there, followed by a 0.5% contraction during the final quarter last year.

While the U.S. has seen better GDP figures, economic growth at 1.8% slowed during the first three months of this year, after expanding 3.1% during the previous quarter. And many analysts expect growth for the rest of the year won’t be enough to help the unemployment picture.

Now with the Fed’s QE2 program expected to end later this month, the growing call to control inflation expectations might just quiet down a bit.