WEST CHESTER, PA. (TheStreet) -- There is little doubt that the Federal Open Market Committee is eager to begin normalizing monetary policy and that the middle of 2015 is the target for its first interest rate hike since 2006. But with the economic environment still uncertain, this policy could backfire and the central bank would do better to remain flexible.
Historically, equities have not done well when the Federal Reserve raises rates -- one reason to expect low single-digit gains over the next couple of years. Rising interest rates will actually be good news for the economy, a signal of strength and improved confidence by the central bank. The data will indicate when the proper time has arrived, and that could be later than June 2015.
In its December post-meeting statement, the FOMC insisted it would remain "patient" while assessing when to begin normalizing monetary policy. The committee included a qualifier, however, saying its stance remained consistent with its earlier guidance that it would hold rates low for a "considerable time."
Such ambiguity is typical for central bankers, who prefer to keep their options for responding to a changing economy open. Yet, Fed Chair Janet Yellen defined "patient" as meaning the Fed would not increase interest rates for "at least the next couple of meetings," scheduled for January and March. This would rule out an increase only until April, sooner than most observers anticipate the Fed will act. We also do not believe policymakers will raise rates that soon.
Predicting what the Fed will do is different from having an opinion about what it should do. The Moody's Analytics baseline forecast currently pencils in an increase in the target fed funds range for June. However, a strong case can be made that the Fed should wait longer than that, even allowing the economy to run hot awhile, to make up for the below-target inflation of the past few years. This could mean keeping rates near zero into 2016, a strategy that would bring both potential benefits and costs.
It is easy to craft a scenario in which inflation struggles to get far above 1% next year. The recent sharp drop in oil prices will shave more than 0.5 percentage point off consumer price growth. Yellen made it clear Wednesday that she does not find low inflation worrisome, attributing it to energy prices that normally have only transitory effects on underlying inflation. She is correct, but other factors are at work that could put downward pressure on core inflation, including an appreciating U.S. dollar. There is little indication that the dollar's run will end in 2015.
November's consumer price index was surprisingly weak, but it would be uncharacteristic for the Fed to react to a single monthly inflation report. However, policymakers need to be mindful of both market- and survey-based measures of inflation expectations. The Fed may find itself trying to jawbone inflation expectations higher. For central banks, credibility is difficult to build and easy to lose. The Fed may have to fight a little harder to keep markets in line, as risks are rising that inflation will remain too low even longer.
It will not be a surprise if the Fed begins to back away from the idea of raising rates in mid-2015. The FOMC's latest interest rate projections did not square with the statement or their economic projections. Policymakers anticipate stronger growth and a lower unemployment rate next year, but interest rate projections drifted lower. While they have cautioned against reading too much into changes in rate projections, the slight drop for next year suggests that a mid-2015 rate hike may not be set in stone.
Read Ryan on Moody's Analytics Dismal Scientist.
The U.S. job market has improved, but low labor force participation and slow wage growth remain significant issues. Policymakers can approach this in several ways. They can assume labor force participation will not respond to wage growth. This would mean the U.S. is near full employment, and thus inflation will accelerate quickly if the Fed fails to raise rates soon. A second approach would be to assume that the labor force will eventually respond to faster wage growth and simply wait for that to happen, holding to the current course of near-zero interest rates and continued, if diminishing, monetary stimulus.
A third approach would focus on productivity growth, which could remain suppressed by under-investment for several more years. This would hurt wages and keep many out of the labor force longer. Since higher interest rates would likely undermine investment, in this case the Fed would choose to be patient.
The wait-and-see approach would allow time to see which story is correct: Either wages will rise and attract workers back to the labor force, or they will not. In contrast, a decision to raise rates soon would leave the structural-versus-cyclical question unanswered.
So why the urgency to raise rates? One concern is financial stability. Keeping rates lower for longer makes the central bank appear irresponsible, potentially undermining confidence. However, the Fed may want to be "responsibly irresponsible." Being slightly behind the curve could drive the unemployment rate lower and wages higher, encouraging firms to seek out workers more aggressively. This could reduce the number of long-term unemployed, who risk becoming permanently unemployable.
The Fed and financial markets appear to be roughly on the same page regarding when interest rates will rise. Opinions differ on the pace of tightening, but this can be worked out over time. In the past, the Fed has raised rates more than it had led markets to expect. We expect something similar this time.
The only question is whether policymakers will listen to the economy and raise rates at the appropriate time. A case can be made that this will not be in mid-2015.
Read Ryan on Moody's Analytics Dismal Scientist.