This is a fight for the soul of the Fed

On the implications of today's looming interest rate hike

At 2 p.m. today, the Federal Reserve is expected to raise interest rates for the first time in nearly a decade.

The Fed has kept rates at zero for seven years, and pressure to finally end that unprecedented run is mounting, even as a growing movement is pushing the Fed to keep rates where they are. A bevy of economists and commentators have weighed in, and every media outlet with any interest in economics is primed and ready for today's announcement, which will undoubtedly be one of the most widely anticipated and watched moments in the Fed's history.

And yet... all chatter suggests the hike will be the smallest increment the Fed can possibly manage: from 0 percent to 0.25 percent. On top of that, the Fed eventually wants to hit 3.5 percent — much lower than the pre-Great-Recession target of 5.25 percent. And it's expected to proceed extremely gradually toward that new, lower target.

From that standpoint, the whole deal seems considerably less exciting. So why all the drama?

Two reasons. One is a matter of technical economics. But the other is considerably more philosophic — even, dare we say, moral.

The technical question is how to read the signals coming from the economy. The Fed's dual mandates are to keep inflation low and stable while maximizing employment. These two goals are fundamentally in tension with each other. Inflation happens when economic growth, and thus job growth, and thus wage growth, are all so high that productivity increases can't keep up. So the only remaining valve to release the pressure is higher inflation. This circumstance is generally called "full employment."

In other words, when the Fed sets out to slow inflation by raising interest rates, what it's literally doing is squeezing the supply of credit to slow down job and wage growth. So the Fed needs to be really sure we're at full employment.

Right now it's just not clear. The official unemployment rate is relatively low, but there are lots of reasons to think it's not actually a terribly good metric for full employment. There are lots of better metrics, which all suggest the labor market is still a long way from healed.

The Fed has already wrongly projected rising inflation at several points since 2008. And among many bastions of mainstream economic thought, there's been a lot of hand-wringing over how weird it is that inflation has been a no-show even as we close in on full employment. But this assumes we're actually close to full employment. If we're not, there's no mystery.

And if the assumption that inflation is being held down by temporary forces — the slide in oil prices, the strength of the dollar relative to other currencies — is wrong, and it's actually more fundamental economic forces at work, then there's a real possibility that even this small hike will do damage to the U.S. economy.

Which brings us to the moral question. Since the Fed's job inescapably boils down to weighing competing risks, it must make a choice: On whose behalf should it take the biggest risks? Most of history's big moral and religious thinkers would answer that the Fed, like our society as a whole, should be judged by how it treats our society's weakest and most vulnerable members. Within the Fed's purview, that would be the poor, the unemployed, racial minorities, the disabled, people with criminal records, and so on — everyone who lives at the ragged margins of the "income distribution system" that is the U.S. economy and labor market. These are the people who will be helped the most if the Fed takes a gamble and pushes the jobs supply and wage growth as high as possible. And they'll be the first to pay the price should the Fed decide to hit the brakes.

Fed officials' fixation on inflation is completely at odds with this sort of moral prioritization. Inflation and low interest rates are mainly problems for the financial industry and rich savers. What's much worse for workers and poor savers is when the whole economy is in the doldrums.

Some observers believe the Fed needs to get ahead of a possible rise because monetary policy operates at a lag. This is bogus. The Fed is having trouble hitting their inflation target of 2 percent, never mind getting above it. The economy has operated fine at 4 percent inflation. The infamous stagflation of the 1970s was well over 6 percent. We'll have lots of room to overshoot, and lots of time to rein inflation back in if it does start rising unexpectedly. There's no need for big and sudden rises in interest rates, as some Fed officials hint.

On the flip side, once short-term interest rates hit zero, the Fed's tools for continuing to boost the economy are experimental and uncertain. So the human damage that will result from lackluster job and wage growth that just keeps grinding along vastly outweighs the risks that inflation will get out of control.

One counter argument is that if another recession hits, the Fed needs interest rates at 3 percent or so to give it enough room to cut to boost the economy. So we need to get back to that level. But you can't put the cart before the horse by just mandating higher interest rates; the only way to sustainably keep them high is with an economy that's actually growing robustly and providing lots of opportunities for investment. The chances we can get to 3 percent before the next recession are basically nil. We'd all be better served if the Fed just kept trying to drive employment and wages as high as possible.

Even if today's interest rate hike doesn't damage the recovery, the question of when to start raising interest rates is a fight for the mind of the Fed. Because right now, the way Fed officials think about the economy — the model of how it works that they hold in their collective head — is fundamentally flawed. And that's no good.

But more deeply, this is a battle for the Fed's moral soul: who it will fight for, and who it won't, when the chips are really down.


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