Why the Fed Needs to Hike Rates Soon

This conundrum is bedeviling today's stock market: If the Federal Reserve hikes rates, it's bad news for stocks. If the Fed doesn't hike rates, it could be worse news.

A growing minority of Wall Street investors thinks the Fed could be on the verge of letting inflation spin out of control. And that possibility gives credibility to fears about a repeat of 1994. That year, the Fed went on a rate-hike rampage, doubling interest rates through seven rate hikes that ended with a huge, three-quarters-of-a-percentage-point jump in November 1994.

Fed inaction in June could add to investor jitters. In a stock market driven by worries and emotions, that would be a big negative.

Rate-hike fans see a dark scenario unfolding if the Fed doesn't move. Their fears can be summed up like this: The Fed has kept its attention focused for too long on deflation and on the danger that falling prices would choke off business investment and stall the economy. The latest May 4 statement from the Federal Open Markets Committee, its policymaking arm, still calls the dangers of deflation and inflation about even: "The risks to the goal of price stability have moved into balance."

Inflation worrywarts say that this ignores evidence that inflation has increased, and that further increases are building. They say the Fed has only a limited time to act before expectations of future inflation get embedded in the economy and in consumer and business behavior. Once that happens, history shows, it takes more than a few 25-basis-point rate hikes to stamp out that inflationary psychology. Which is why, these investors say, the financial markets should worry about a replay of 1994 if the Fed doesn't act now.

This argument, of course, depends on the strength of the evidence that inflation is picking up.

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