The Birds and the Bees of the Fed’s Rate Hike Debate

When Federal Open Market Committee members are loving low inflation, they make a rate hike. But it’s an important decision, and there are some facts we all need to know so we don’t get pressured into rate hikes before the economy is ready.

After yesterday’s Fed minutes release, it’s time we had an adult conversation about where the Federal Reserve’s interest rates come from and whether we’re ready to raise interest rates. We probably will soon, but we probably shouldn’t. It’s not cut and dried: economists have argued for decades that monetary policy operates with long and variable lags—that is, the Fed can’t just wait for inflation to hit a target, flip a switch, stabilize inflation, and have the economy move on from there. But an analysis of the actual economic conditions we’re looking at doesn’t suggest we should be raising rates anytime soon.

To understand what’s going on, it’s important to step inside the Fed’s monetary policy process. The Fed has economic benchmarks—for a while it has targeted a 2 percent inflation rate, a figure some experts think is too low—to ground its long-term policy, and actual changes in interest rates are set by the FOMC. But with inflation, core inflation and inflation expectations all well below the Fed’s stated two percent target, the overarching policy says the Fed should be at least as likely to cut rates as to raise them. To understand why Fed watchers say rates are going to rise soon, we need to talk about where FOMC members come from.

The FOMC is made up of members from the Fed’s Board of Governors—a group of seven appointed by the president and confirmed by the Senate—plus the president of the New York Fed and a rotating group of five presidents of the 12 Federal Reserve banks across the country. But thanks to the Senate’s intransigence, the pace of the approval process for new Federal Reserve board members has slowed in this administration. Most memorably, Nobel Prize-winning economist Peter Diamond gave up on the confirmation process and went back to being an MIT professor. As a result, the Fed board has fewer members, just five, and therefore fewer votes and less influence than usual.

This matters because regional bank presidents tend to be more hawkish on inflation. Many come from a banking background where the business costs of inflation are ever-present, rather than a macroeconomic one, where it can take a lot of work to show inflation has a real cost.

The Fed Board in D.C. has more economists and macroeconomic modeling capabilities than outsiders could dream of matching, with even more talent at the regional Fed banks. But these experts don’t set interest rates, they just produce internal projections that FOMC members can use to inform their policies. (They also produce some very cool, very nerdy research.) We know more than usual about what these economists think and what the Fed’s models show because the Fed accidentally published a staff forecast six years early, and it shows inflation still below the Fed’s target in 2020. In other words, the technical experts aren’t the ones pushing for rate increases.

So why are we so confident the Fed is close to raising interest rates when its stated policy and modeling capabilities say otherwise? It’s all about the dots. The Fed releases plots that show where FOMC members expect interest rates to be at various points in time, with each dot representing an anonymous prediction.

Embedded in these predictions is not just a forecast but a statement about where the economy is headed, as well as the preferences of FOMC members. Forecasting is hard and mistakes are to be expected, but systematically biased ones are problematic precisely because they are informative. Ever since the topline unemployment rate started falling, these dots have said that either inflation predictions consistent with market prices are too low, or that FOMC members have lower inflation targets than the officially stated 2 percent rate, or both.

The question now is: what will give? Policy that is inconsistent with inflation targets risks future credibility—indeed, markets are already discounting the dots because they have been so far off for so long, but it also devalues the information contained in the dots. So far Fed watchers are betting on itchy trigger fingers, and assuming FOMC members will be essentially unconstrained by data and the Fed’s longterm guidance.

Perhaps a more defensible rationale is that the Fed is trying to raise rates ahead of inflation not because it fears the economy is heating up too quickly, but because it needs to start soon if it wants to raise rates gradually in an approach otherwise known as “gradualism.” Proponents of gradualism note that bond markets prefer predictable paths of rate increases. But recent academic research suggests that this gradualism could actually have serious longterm costs, and holding off on rate increases until there are real signs of inflation is better policy.

One of the authors of that paper, Jeremy Stein, is an expert on central bank communication at Harvard. Hopefully he’s imparted some of this wisdom to his former colleagues on the FOMC.


Michael Madowitz is an economist at the Center for American Progress.

Morning Consult