Raising Rates Too Early Could Be Disastrous

The Federal Reserve definitely seems to be gearing up for monetary tightening, even though inflation remains below target. And I agree with Ryan Avent at The Economist: If this happens, it will be a big mistake – just as European Central Bank President Jean-Claude Trichet’s decision to raise interest rates in Europe in 2011 was a big mistake, just as the Swedish Riksbank’s early rate hike was a mistake, just as Japan’s rate hike in 2000 was a mistake.

And you would think that Fed officials would understand that. In fact, I suspect they do, and are somehow letting themselves be bullied into doing the wrong thing anyway. More on that in a minute.

First, on the policy substance: The point is not that we know that the American economy is still far from full employment. The question is one of weighing the risks. The fact is that the damage the Fed would do if it hikes rates too soon vastly outweighs the damage it would do if it waits too long.

Suppose the Fed does the latter. Well, inflation ticks up, but probably not by much. It would be annoying and unpleasant, and no doubt there would be congressional hearings berating the Fed for debasing the dollar. But it wouldn’t really be a big problem.

Suppose, on the other hand, that the Fed raises rates, and it turns out that it should have waited. This could all too easily prove disastrous.

The economy could slide into a low-inflation trap in which zero interest rates aren’t low enough to turn things around – which has happened in Japan and is pretty clearly happening in the eurozone. Also, there is now very strong reason to suspect that a protracted slump could inflict large losses on the American economy’s future productive capacity.

If someone tells you that these risks aren’t that big, consider this: We used to be told that a 2 percent inflation rate was enough to make the risks of hitting the zero lower bound minimal – less than 5 percent in any given year. But of the roughly 20 years since inflation dropped to around 2 percent, six years – or 30 percent of the time! – have been spent in a liquidity trap. This means that we should be very afraid of missing our chance to escape from the trap out of an urge to normalize monetary policy too soon.

The thing is, I know that Fed Chairwoman Janet Yellen, Vice Chairman Stan Fischer and the Fed staff know this. They’re very familiar with recent history and all the relevant economic analysis. So why do they seem to be rhetorically preparing the ground for early rate hikes?

My guess – and it’s only that – is that they have, maybe without knowing it, been bludgeoned into submission by the constant attacks on easy money. Every day, the financial press, as well as many blogs and cable financial news outlets, feature people warning that the Fed’s low-rate policy is distorting markets, building up inflationary pressure and endangering financial stability. Hard-money arguments, no matter how ludicrous, get respectful attention, and condemnations of the Fed are constant.

If I were a Fed official, I suspect that I would often find myself wishing that the bludgeoning would stop, at least for a while, and that perhaps I would begin looking for an opportunity to prove that I’m not an inflationary money printer.

So my guess is that the Fed, given an improving job market in the United States, is strongly tempted to buy some peace by raising rates a little just to quiet the critics for a few months.

But the objective case for a rate hike just isn’t there. The risks of premature tightening are huge, and should not be taken until we have a truly solid recovery that includes strong wage gains and inflation clearly on track to rise above target.