The Fed Should Raise Rates Next Month

Patience has its limits.

Photographer: Aaron P. Bernstein/Getty Images

Inflation in the U.S. rose in the year that ended in January by 2.5 percent -- faster than expected, and well above the Fed’s target of 2 percent. It was the latest sign that the economy needs a rise in interest rates when the Federal Reserve’s policy-making committee meets next month.

Before the new inflation number, most analysts had thought the next rise would come later in the year. Afterward, it looked like a closer call, with trades in derivatives suggesting a probability of roughly 40 percent that the mid-March meeting would raise rates. That should make it easier for the Fed, which doesn’t like to surprise investors, to do the right thing.

The central bank has long said it will be patient about getting monetary policy back to normal, not wishing to stifle a recovery that’s been no better than tepid. But it has also said that its interest-rate decisions won’t be tied to a fixed schedule, but will depend on data as it arrives. The new figures tilt the balance in favor of further tightening, sooner rather than later.

Granted, the signal from inflation is more ambiguous than you might think. The unadjusted index of consumer prices is distorted month to month by swings in volatile energy and food prices. The Fed prefers to keep an eye on a different measure of inflation -- the price index of personal consumption expenditures. This went up by 1.7 percent, excluding food and energy, in the year to December, still a little below the central bank’s inflation target.

In addition, the current low unemployment rate of 4.8 percent most likely exaggerates the tightness in the labor market. As the economy expands, some of the many workers who’d previously dropped out of the labor force altogether (and therefore don’t count as unemployed) have started looking for jobs. This is why, despite rising employment, the jobless rate actually edged up in January. An expanding labor force gives the economy a bit of additional headroom.

Yet bear in mind that the Fed’s current policy stance is anything but neutral. The short-term interest rate stands at 0.5 to 0.75 percent -- low by historical standards -- and the Fed’s balance sheet, swollen by large-scale bond-buying operations, continues to supply strong monetary stimulus. A quarter-point  rise in rates next month would only make the Fed’s policy a little less expansionary.

A balance has to be struck. Moving too soon risks choking off some jobs that might otherwise be forthcoming. But waiting too long could leave the Fed no choice but to tighten policy abruptly amid fears of a surge in inflation -- and that would be much worse for jobs. There’ll be fresh data between now and the next Fed meeting, but as things stand, choosing not to nudge interest rates higher in March would be taking patience too far.

To contact the senior editor responsible for Bloomberg View’s editorials: David Shipley at davidshipley@bloomberg.net.