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Behind the Fed's Faulty Logic on Interest Rates

Ramesh Ponnuru is a Bloomberg View columnist. He is a senior editor of National Review and the author of “The Party of Death: The Democrats, the Media, the Courts, and the Disregard for Human Life.”
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Interest rates are on the way up, and policy makers at the Federal Reserve want to dispel any doubts you have about it. In the minutes from the Fed’s latest meeting, “most participants” said that raising rates in June “likely would be appropriate” if the economy continues to improve. Presidents of two of the regional Feds said two more increases could follow later this year.

Higher rates, then, have broad support inside the Fed. All they lack now is a convincing rationale.

According to the minutes, an increase in June is contingent on three developments: “economic growth picking up in the second quarter, labor market conditions continuing to strengthen, and inflation making progress toward the [Fed’s] 2 percent objective.”

A strong economy and healthy labor markets are reasons not to fear a rate increase. But it would be perverse to view them as reasons in themselves to raise rates, as though the central bank needs to act to keep all this good economic news from getting out of hand.

If inflation were threatening to rise too high, on the other hand, that would be a good reason for higher interest rates. But as the minutes acknowledge, inflation is currently below the target, and the Fed is not waiting to hit it before it tightens monetary policy. The Cleveland Fed estimates that the market expects an average annual inflation rate of 1.75 percent over the next 10 years. So the Fed’s announced inflation objective does not justify a rate increase either.

Perhaps it has other motivations. One clue is the use of the word “normalization” in the minutes: The Fed shares the widespread view that the prolonged period of low interest rates we have been experiencing is abnormal and needs to change. Central bankers may also want more room to maneuver in the event of a recession: It won’t be able to reduce interest rates very far if they are already low, so why not raise them when the economy is doing well?

Additionally, the Fed’s inflation “target” may not be a target at all. If it were, then the Fed would be roughly equally concerned about the prospect of undershooting it as it is about overshooting it. In practice, however, the Fed seems very intent on avoiding inflation exceeding 2 percent and fine with inflation under 2 percent. The “target,” in other words, is really a ceiling. 

It may sound like a good thing that inflation is expected to run lower than 2 percent. But the Fed should be clear on what its goal actually is. Persistently falling short of the goal also sacrifices some of the value of having it in the first place. A benefit of an inflation target is that it makes the price level predictable over time: You can be confident that on average prices will be roughly 2 percent higher next year, and 2 percent higher than that the year after. But the longer the Fed lets inflation stay below this target, the more the actual price level diverges from the targeted one.

An inflation ceiling also poses risks in the event of an economic contraction like the one we had in 2008-09, when inflation fell. If it maintains its ceiling, the Fed will not allow any temporary increase in inflation to make up for a previous shortfall -- a policy that can inhibit a recovery. If the Fed really wants more power to stimulate a future depressed economy, in other words, it should be reconsidering its ceiling rather than raising rates.

The trouble with the view that the Fed should “normalize” interest rates, meanwhile, is that low rates may be the new normal, the result of economic conditions beyond the central bank’s control. And it is awfully close to saying that higher interest rates are an end in themselves.

That dubious assumption seems like the only way to make sense of the Fed’s current plan.

This column does not necessarily reflect the opinion of the editorial board or Bloomberg LP and its owners.

To contact the author of this story:
Ramesh Ponnuru at rponnuru@bloomberg.net

To contact the editor responsible for this story:
Katy Roberts at kroberts29@bloomberg.net