THE last time the Federal Reserve raised its benchmark interest rate, there was no one to tweet about it. That rise, in June 2006, predated Twitter’s public release by a month. Nine years on, as the Fed readies itself to raise rates again, the public debate between hawks and doves is much noisier. Markets reckon that the Fed will raise its benchmark rate at least once this year, from the 0-0.25% range it has targeted since December 2008—and perhaps do so as soon as its next rate-setting meeting on September 16th-17th. But here, it does not pay to go early: a rise now would needlessly risk America’s recovery.
On the face of it, the case for a rise looks perfectly respectable. The American economy is at its fittest in more than a decade. It grew at a 3.7% annualised pace in the second quarter of 2015; after a brutal period of post-recession deleveraging, consumers are spending again. Firms have been hoovering up workers, creating jobs at a rate of about 3m a year, the best performance since 1999 (see article). In August the unemployment rate fell to 5.1%. The Fed has repeatedly assured markets that its rate increases will be gradual and gentle: hawks argue that slightly higher rates will not derail the economy.
They also brush aside low inflation. The Fed’s preferred measure, which has been below its 2% target for more than three years, stood at 0.3% in July. Yet the central bank is meant to look ahead when making its decisions. With unemployment so low, the Fed is confident that firms will find themselves forced to boost pay to attract workers. That should lead to higher prices. Meanwhile, the effects of falling oil prices and a rising dollar, which have depressed inflation over the past year, should soon abate, allowing inflation to climb back to 2%—and perhaps higher, if the Fed does not act soon.
Hawks make a third argument for speedily escaping the abnormal world of near-zero interest rates. With borrowing costs so low, they say, it is only a matter of time before yield-hungry investors take on extravagant risks, laying the groundwork for a future financial calamity. The sooner the economy permits a return to higher rates, the better.
Act in haste
Look closer, however, and this case is flawed. A looming rise in inflation is anything but certain. Although the unemployment rate is low, other labour-market measures suggest willing workers are waiting in the wings. Labour-force participation among workers aged 25 to 54 has yet to recover from its recession swoon. Wage growth, at 2.2%, has scarcely risen in four years and remains well below levels reached during the previous three recoveries. That suggests firms can still draw on a reservoir of underemployed workers—which should keep a lid on wages and prices. The financial risks from ultra-low rates have been reduced by tougher regulation.
In addition, the Fed is moving to tighten just as the global economy is weakening. That is not just a concern to wobbly emerging markets, which fear that rising interest rates in America will prove a magnet for foreign capital. The dollar, up by nearly 20% over the past year on a trade-weighted basis, may float even higher, squeezing American exporters and dragging down inflation. Small wonder markets signal that they expect inflation to remain below 2% for the next few years.
On its own, therefore, the balance of probabilities argues against a rise. But the clinching argument against the hawks is that they ignore a fundamental asymmetry of risks. If the Fed waits too long to tighten, then inflation will rise above 2%. Were that to happen, the Fed has unlimited capacity to raise rates and could do so safe in the knowledge that it had pushed the American economy to its speed limit. If rates then had to rise steeply, the central bank would at least have more room to respond to future troubles by cutting again.
Raising rates too soon would be much costlier. A slowdown in growth could turn low inflation into deflation. To perk the economy back up, the Fed would have little option but to restart quantitative easing. That sort of backtracking is precisely the fate that has befallen other central banks which moved to tighten too swiftly (see article). Years of rock-bottom interest rates in Japan might have been avoided had the Bank of Japan been a little more patient in 2000, when it lifted rates in response to quickening growth (and higher stockmarkets) despite falling prices.
Low interest rates have risks. But premature rate increases can make them a near-permanent feature of economic life. For months Fed statements have declared that inflation will soon return to 2%. There is little harm in waiting to be sure.