No, The Federal Reserve Should Not Be Tightening Right Now. Why Do You Ask?

The argument that ought to be decisive in convincing the Federal Reserve as currently structured to not tighten but loosen over the next year is that in order to establish credibility that its 2%/year inflation target is an average, and not a ceiling, it needs to overshoot it for a period of time in the near future. The other arguments–that the Federal Reserve should be aiming for 4%/year inflation or 6%/year nominal GDP growth, that it needs to explore the policy space in order to learn more about the current structure of the economy and the location and slope of the Phillips curve (if any), that it needs to act responsibly as the global monetary hegemon rather than irresponsibly as an organization with a narrow focus exclusively on the US internal balance–ought to be decisive too if the Federal Reserve Open Market Committee were properly constituted. But given how the Federal Reserve Open Market Committee is currently constituted, they are not.

But the need to establish credibility that the target is 2%/year rather than ≤2%/year really ought to be decisive.

We have Tim Mullaney and Matt O’Brien making other very cogent arguments. Mullaney says–I believe correctly–that the Fed’s models are predicting a rise in inflation that is more likely than not to once again evaporate:

Tim Mullaney: 4 reasons we know we’re not ready for the Fed to raise rates: “Many investors would like a clearer standard for when the economy is ready for rate hikes…

…Here are four bars it should have to clear. And it hasn’t cleared any yet: [1] 250,000 jobs a month, pretty consistently…. The jobs report misses that test. It’s been generating more like 212,000 this year…. [2] Above-trend economic growth, pretty consistently…. If third-quarter tracking estimates hold up, the first nine months of this year are at about 2.2%…. Central banks should feed economies until they break through the trend, and pull money out as above-trend growth moves us toward inflation…. [3] Real full employment: To hear business-as-usual pundits tell it, we’re at full employment. But we’re not….

[4] Signs of capacity or cost pressures: The reason the Fed raises rates isn’t to reimpose Protestant virtue lost when money is cheap and investment gets as licentious as a cheerleader. It’s to prevent inflation. And while Fed Vice Chair Stanley Fischer argued last week you don’t always see inflation coming before it’s too late, it’s not too late. Begin with the still-slack labor market, and especially the 2.2% increase in average hourly wages over the last year. Then add weak capacity utilization and business investment…. Inflation is several steps away–labor markets must tighten more, wages have to rise, and business has to fail to offset the higher pay by accelerating productivity. There’s a reason the Fed staff’s leaked projections in July saw sub-2% inflation until 2020…

And O’Brien that outside observers have given up saying that the Fed must start to type because inflation is just around the corner, and started saying that the Fed must tighten just because:

Matt O’Brien: “People used to say the Federal Reserve had to raise rates to fight nonexistent inflation…

…Then they said the Federal Reserve had to raise rates to fight nonexistent bubbles. And now they say the Federal Reserve has to raise rates for nonexistent reasons. Just, you know, to show that it can. This is not progress….

The Fed, after all, doesn’t want to wait until the economy is obviously overheating to start raising rates, but rather right before it does so. The only problem with that is there aren’t any signs the economy is anything other than properly heated right now. Workers still aren’t getting bigger raises, just 2 percent a year compared to the 3.5 to 4 percent they normally would, and inflation is still dead at just 0.3 percent. That picture doesn’t change even if you strip out volatile food and energy prices, with so-called core inflation at only 1.2 percent, and not even trending up….

But some people are tired of this debate. The Fed hinted it might raise rates now, and, by golly, that’s what they want it to do, whether or not the data actually support that. ‘What are you worrying about, September or December,’ former Fed governor Laurence Meyer wondered, when ‘it doesn’t matter’ and the Fed should ‘just pull the trigger.’ Economist Tyler Cowen said he ‘would consider a ‘dare’ quarter point increase just to show the world that zero short rates are not considered necessary for prosperity and stability.’ And New York Times columnist William Cohan implored the Fed to ‘show some spine’ and start hiking despite the sell-off.

These are psychological arguments, not economic ones.

As Larry Summers says, if the federal funds rate were 4% right now few would be thinking of raising it. You do have to strongly believe in “normalization”. If you were a Bernanke, and believed that the policy deviations in emerging markets that created the global savings glut are on the way out, there might be a case. Or if you were a Rogoff, and believe that the deleveraging cycle was almost completed, there might be a case. But Carmen Reinhart is saying “wait”. And I really did not think that Janet or Stan thought like Ken or Ben.