Why the Fed Needs to Make a Policy Error

Samuel Rines

Economics, United States

Raising rates now is a bad idea, but not raising rates would damage the Federal Reserve's credibility.

One way or another, the Fed’s current policy path will be remembered as a comedy of errors. But what will matter more than the mistakes is whether or not the Fed maintains its credibility. By so consistently telegraphing interest-rate hikes, the Fed has backed itself into a corner. It may be a policy error to continue raising rates at this point, but backing away from higher rates could spark a crisis of confidence, which would be even worse. The Fed is setting up to commit a policy error, and an error may be the best possible outcome now.

The oddity of the Fed’s current position is the near guarantee that it will make a policy error. With little in the way of inflation and a nascent rebound in wages continuing to lag prior recoveries, the Fed has still committed itself to “normalizing” interest rates. Precious little inflation pressure is appearing, economic growth remains anemic, and the uncertainty surrounding global deflation shocks remains significant.

The Fed has cited the aforementioned as reasons for its slow and gradual approach to the process of tightening policy. Fed presidents frequently reiterate the primacy of data dependency in their policy-determination process, while emphasizing the lack of a preset course for future policy. But the language is typically unidirectional—always focused on what data are needed to justify a rate hike. No one talks about what would constitute evidence for a reversal. And this creates complications for the Fed’s ability to prudently conduct both present and future monetary policy.

The Fed understands there are few, if any, reasons raising that interest rates is imminently necessary. The reasoning to normalize policy is more that “it must be done” than that “it needs to be done.”

The logic as to why the Fed must remain on a tightening path is that it cannot afford to lose credibility. More accurately, it cannot afford to lose credibility in that way. By committing the policy error of misreading the economy, and significantly slowing an economic expansion, the Fed risks less credibility than it would by backtracking on it policy path. The Fed must maintain faith in the execution of its commitments and policies.