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Fed shouldn’t normalize rates before the economy is back to normal

The Fed’s next dilemma: One and done? Or should it raise rates at a regular pace?

Inflation is very low.

(MarketWatch) — We’re about to find out the price of gradualism for the Fed.

We shouldn’t overreact to short-term signals, but a good month of jobs data and a Federal Open Market Committee statement with the subtlety of a sledgehammer suggest that even though economic data say that a rate hike is inconsistent with the Fed’s long-term positions, an increase is nevertheless looking pretty likely next month.

What comes next is going to be interesting. Should we assume the Fed is committing to a normal series of rate increases we would expect following a recession?

Complicating any analysis of the Fed’s medium-term goals is a dearth of inflation.

Just this week we saw more research from Fed economists making the point that if you look really hard for inflation, you still don’t see any signs it’s on the way. It’s true that predicting inflation is hard, even for markets, but an interest-rate hike at this point — where nobody sees inflation on the horizon — makes it very hard to identify the Fed’s planned path over the next year. It all depends on what the Fed thinks about the real economy, and whether that matters.

WSJ Opinion: Republicans and Sound Money

Money Strong President Danielle DiMartino Booth on the emerging debate about the future of the Federal Reserve and the value of the dollar. Photo credit: Getty Images.

Earlier this year, advocates of a rate hike made the case that getting above zero was a priority. So much so that a little hike and a long pause was put forward as sensible policy. That may yet be the plan — and the fundamentals of the real economy suggest it is the most appropriate plan that involves a rate hike. Of course this plan has major downsides — if you take the risk of recessionseriously, we’re talking about setting up speed bumps in the Fed’s ability to respond to a negative shock.

Another possibility is the Fed is planning a more normal path of rate increases. Some market-based forecasts now show a significant chance that rates will be above 1% by this time next year. While that view is even more at odds with the real economy we expect in 2016 right now, it is perhaps more consistent with a central bank that is hoping to get back to normal interest rates sooner than macroeconomic conditions warrant.

In other words, some forecasters think we could see normalization of monetary policy before we see normalization in the real economy. That’s weirder than it sounds, because getting rates back to normal sooner means getting the real economy back to healthy, stable inflation levels slower.

Of course normalization is in the eye of the beholder. It’s clear that equilibrium real rates are lower today than they were before the recession, and if China’s slowing growth is a real thing, this will certainly be true a year from now. The way you normalize policy under these conditions is to get inflation up to normal levels quickly, an idea that doesn’t square with the Fed signaling a December rate increase with all the subtlety of a romance novel.

So what is the Fed’s plan? It’s really hard to say. In this sense, a rate hike in December may be a pyrrhic victory for Fed credibility. It will make all the statements about a rate hike before the end of 2015 true, but it makes it really hard to put stock in any claims about monetary policy in 2016. The Fed can only ignore the real economy so long.

Central banks have spent much of the recovery trying to get ahead of inflation, and in a sense they have succeeded, just too soon and too strongly. The Fed remains a holdout on raising rates, but as we get closer to what looks like a December rate hike, it’s worth noting that you can’t will a rate increase to stick.

Whatever happens over the next month, let’s hope the FOMC can settle on some concrete measures of progress in the real economy to anchor expectations going forward.

Short-term market volatility is not a good thing, but overly hawkish policy that locks in the labor force losses of the Great Recession is a much bigger problem in the long term. If you don’t like super-low interest rates, focusing on the real economy is the way to prevent them in the future.

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

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