NEW YORK (TheStreet) -- The Federal Reserve should end its zero interest rate policy at this week's meeting of the Federal Open Market Committee. The federal funds rate has been at effectively zero since late 2008 when the financial crisis and Great Recession were at their very worst. The economy and financial system have come a long way since then and the need for zero interest rates has passed.
This isn't an easy decision. Indeed, policymakers may decide to wait longer before raising rates. But the longer they wait to normalize monetary policy, the greater the risk they will wait too long and are ultimately forced to raise rates quickly to battle developing wage and price pressures, undermining the economic expansion.
The Fed's decision to begin raising rates hinges on five criteria:
1. How quickly will the economy return to full-employment?
2. When will inflation return to the Fed's 2% target?
3. The stability of the financial system.
4. Global economic conditions and the value of the U.S. dollar.
5. Risk management around the economic costs of making a wrong decision.
Let's consider each in turn.
The case for beginning to raise rates now is strongly supported by the strength of the job market. Job growth is robust and rock-solid at well over 200,000 per month. This is approximately double the growth in the labor force, and thus the remaining slack in the labor market is quickly being absorbed. The estimated underemployment gap -- the percent of the labor force that is underemployed -- has fallen below 1%.
At the current pace of job growth, if sustained, the underemployment gap will disappear and the economy will be at full-employment by summer 2016. There is no reason to believe that job growth will slow any time soon given the recent surge in job openings to a record high and the rock-bottom number of layoffs.
There is a reasonable debate regarding why wage growth remains so pedestrian, and whether this signals that the job market has more slack than thought or that the link between a tightening job market and wage growth has been impaired. More likely, businesses are doing everything they can to avoid bigger pay increases for their workers, which is very typical particularly coming out of a period with a slack job market. However, the rapidly increasing number of open job positions suggests this is no longer working.
A substantive pick-up in wage growth appears imminent.
Inflation at Bottom
Currently, low inflation provides the strongest case for not changing monetary policy. As measured by the year-over-year growth in the core consumer expenditure deflator, inflation is 1.2%. This is well below the Fed's target of 2%. Inflation expectations also appear soft, at least as implied in financial markets (survey-based measures of inflation expectations are stable).
But this largely reflects the collapse in oil and other commodity prices and the much stronger value of the U.S. dollar. These more-or-less temporary weights on inflation account for nearly one-half of the 80 basis point gap between actual and target inflation, according to simulations of the Moody's Analytics macro model. Very modest healthcare inflation is likely also temporarily depressed by the implementation of Obamacare.
Moreover, the growth in the cost of housing, which tends to be very persistent, is accelerating. Households renting their homes have experienced big rent increases of 3.5% over the past year, and the implicit rent paid by households that own their homes has accelerated to 3%. With overall home construction still depressed, record low vacancy rates are sure to fall further, and rent growth will accelerate substantially more.
It is highly likely that inflation will be back to the Fed's 2% target, and then some, two or three years from now.
The recent correction in global stock markets and increased volatility in many financial markets has also given fodder to the argument that the Fed should stand pat and not raise rates.
This is a strained argument. Financial market volatility has certainly increased in recent weeks, but it remains low by any historical standards. The St. Louis Federal Reserve index of financial market stress remains below the average that has prevailed over the nearly quarter century history of the index.
Of the 18 financial market measures that make up the index, only stock market volatility is up significantly, and even that is well within what is consistent with a garden-variety stock market correction. The pull-back in stock prices is a long-time coming given how strongly and consistently stock prices have risen since the recession. Even Fed chair Yellen was recently publicly hand-wringing about the over-valued stock market.
Moreover, it is likely that at least some of the increased volatility in financial markets has been created by the parlor game among investors over whether the Fed will soon raise interest rates. If so, the volatility may actually recede once the Fed finally does move, particularly if it provides more guidance regarding the path of future rate hikes.
It is also important to note that the financial system broadly is in about as good as shape as it has ever been to gracefully weather almost any storm coming from markets. The banking system has never been as well-capitalized and liquid. The stress-testing process has also prepared systemically important institutions for the darkest of scenarios, including much higher interest rates.
Systemic risk -- the risk that financial institutions and markets are highly interconnected and thus a problem somewhere in the system will create a problem for the entire system -- also appears very low.
We measure the systemicness of the system by quantifying the strength of the relationship between the expected default frequencies of publicly traded financial institutions. A financial institution's expected default frequency is a measure of the probability that the firm will default within one year.
Global Economic Threat
International developments are not, as the Fed puts it, at the top of its list of criteria for whether to raise rates, but the struggling Chinese economy and the strengthening value of the dollar are surely on the list.
That the Chinese economy is slowing is no surprise, as authorities have been setting lower growth targets and working to transition the economy from being export- to consumption-led. What is surprising is how poorly the authorities appear to be managing this transition. Their cheerleading of the Chinese stock market during its meteoric rise earlier this year, and their efforts to prop it during its recent collapse, feel amateurish. The authorities also bungled the devaluation of the yuan.
However, despite the missteps, the most likely scenario is that Chinese authorities will rally, and, with their considerable monetary and fiscal resources and control, guide the economy to a reasonably soft landing. China's economy may eventually come crashing down to earth, but that doesn't seem likely any time soon.
There is some nervousness around the Chinese slowdown on the rest of the emerging market economies. Many EM economies sell energy, metals and agricultural products to China, and their sales are suffering. Exacerbating their problems are much weaker commodity prices and their heavy debt loads taken on during the boom times. Current account deficit economies that need capital inflows, such as Brazil, India, South Africa and Turkey, appear especially fragile.
While a concern, these economies have already gone through significant adjustments beginning back in late 2013 when then-Fed chair Ben Bernanke began the discussion around ending quantitative easing in the U.S. The resulting so-called "taper tantrum" caused the currencies of these emerging market economies to fall sharply in value, forcing central banks to tighten monetary policy to head off surging inflation.
It's not been easy for these countries, but to varying degrees, largely depending on how well monetary and fiscal authorities have responded, they are now in a much better position to digest a Fed rate hike. Indeed, the uncertainty over when the Fed will actually begin raising rates may be doing more harm to those much needed capital inflows than an actual rate hike would.
The stronger U.S. dollar, which is up about 15% on real broad trade-weighted basis over the past year, is a headwind to growth, but the economy seems to be managing it well. The nation's manufacturing base is taking the brunt of the weaker trade balance, yet industrial production continues to advance and manufacturing employment is holding firm. Record vehicle sales and production and stronger construction-related manufacturing have offset the negative fallout of the stronger dollar on manufacturing and the broader economy, at least so far.
Moreover, despite the dollar's strength, it remains close to its average value since the collapse of the Bretton Woods agreement and the broad adoption of flexible exchange rates in the early 1970s.
Risk management considerations, which have long favored the Fed holding firm to its zero interest rate policy, are quickly shifting.
Given the considerable uncertainties involved in making monetary policy decision, any decision could turn out to be a mistake. Thus when making a decision policymakers should carefully consider the costs of making a wrong one. In the current context, the cost of raising rates too soon and undermining the expansion is fast fading, while the cost of raising rates too late and ultimately forcing a more aggressive hike in rates that short-circuits the expansion is increasing.
Assessing these risks is ultimately a judgment call, but this is a decision about ending the Fed's zero interest rate policy with at most a quarter point rate increase. It is not about kicking off an aggressive round of rate hikes. Policymakers should make this clear in the statement and press conference that would go along with the decision. The parlor game around when the Fed might hike rates again will begin anew, but it won't have the same intensity or engender the same uncertainty in financial markets.
Raising rates will also allow the Fed to test out the new policy tools it has been experimenting with to push short-term rates higher despite a surfeit of excess reserves. The interest rate on reserves, term deposits and reverse repurchase agreements appear to work well enough, but policymakers won't know how well until they use them under real life conditions.
When assessing the risks of not moving now, policymakers should also consider that the economy appears to have become less interest-rate sensitive. Households and businesses have deleveraged and locked in the low interest rates through aggressively refinancing their debts
Financial institutions are also well prepared for rising rates via the stress testing process, and given the prospects for higher lending rates, welcome them.
There is also the risk that long-term rates don't increase as much as they have historically given rising short-term rates. The European Central Bank and Bank of Japan continue to aggressively buy bonds and global financial institutions are also big buyers of high-quality bonds to meet stiffer liquidity requirements set by global regulators. Given that long rates are being held down by factors unrelated to the U.S. economy's performance, the Fed may be forced to raise short rates even more aggressively to get its desired outcome.
Normative vs. Positive
While the Fed should raise interest rates this week, it is very possible that it won't. Key FOMC members have expressed reticence about a September move, and perhaps most importantly chair Yellen appears predisposed to wait longer.
Swaying her thinking may be a sense of her place in history. Nothing would be worse for her legacy than if she moved too quickly on normalizing monetary policy after the Great Recession. The Fed arguably did this during the Great Depression. The economy, which had contracted sharply in the early 1930s, appeared to be recovering by mid-decade. However, the Fed tightened monetary policy prematurely sending the economy reeling again. Such an outcome today seems like an extreme tail event, but perhaps for Yellen not a risk worth taking.
Chair Yellen may also be motivated by an unstated, but ostensible, desire to run the economy on the hot side. That is, to allow the economy to operate well beyond full employment in order to ignite much stronger wage growth and perhaps even above-target inflation, at least as long as inflation expectations remain tethered. She oft expresses a concern over the skewed income and wealth distribution, and what better way to address this problem than for an extended period of out-sized wage growth. Monetary policy may be in part responsible for the declining share of national income going to workers, as the Volker and Greenspan Feds worked to bring down inflation by running a cold economy that was more often than not operating shy of full-employment (remember Alan Greenspan's stated policy of "opportunistic disinflation").
Whether the FOMC votes to raise rates appears to be a game-time decision, determined in part by the dynamics of the group, how well different points of view are expressed and how strongly those views are held. If policymakers decide to wait to raise rates on another day, hopefully that day isn't too far off. Zero interest rates are no longer a healthy place for this economy.
This article is commentary by an independent contributor. At the time of publication, the author held no positions in the stocks mentioned.