Now, if you only look at the headline numbers, it really does seem like the Fed should be raising rates. Unemployment has fallen to 5 percent and should continue to do so since we have been adding an average of 218,000 jobs the last three months. The economy, in other words, has returned to normalcy, so interest rates should too—right? Well, maybe not. The problem is that there is still a fair amount of what Fed Chair Janet Yellen calls "shadow unemployment" left. Those are people who can only find part-time jobs but not the full-time ones they want, or have given up looking altogether for now. And that, at least in part, explains why inflation is so nonexistent. It is well below the Fed's 2 percent target due to the oil collapse, but that would still be true, albeit to a lesser extent, even if you stripped out volatile food and energy prices. That's because, despite a healthy-sounding unemployment rate, workers haven't been getting anywhere near the type of healthy-looking raises that would help push up prices. The danger, then, is that the Fed raises rates so soon that the economy stalls out, inflation falls further, and it has to reverse course in rather short order.
That, after all, is what has happened to every other country that has tried to raise rates from zero. The simple story is that central bankers tend to pride themselves on choosing the hard rate hike right over the easy inflationary one wrong, and will look for any excuse to do so when interest rates are zero—even if it means inventing them. That, more or less, is what Europe, Japan and Sweden all did in recent years, and, as a result, all of them ended up back where they started—zero—soon thereafter.
The Fed, of course, is aware of all that, and doesn't think it's making the same mistake now. Instead, it forecasts that inflation will increase towards its 2 percent target as workers hopefully start getting bigger raises, the dollar stops rising, and oil price stop falling. And since monetary policy operates with what economist Milton Friedman called "long and variable lags," the Fed thinks it needs to start raising rates today to keep this expected inflation in check tomorrow. Well, almost. It really thinks it needs to do so to keep this expected inflation in check tomorrow without causing an unnecessary recession.
This is the tricky part. "I think it's a myth," Yellen said, "that expansions die of old age," although she did concede that central banks can kill them with higher interest rates. The question, though, is how to avoid that. One answer is that, especially after the crisis, you shouldn't increase interest rates until there is actual evidence of increasing inflation. That way you know—and not just expect—that the economy is ready for higher rates when you do hike them. The only problem with this, as Yellen pointed out, is that if the Fed did wait to raise rates, it might have to raise them faster to keep a lid on inflation—and that could very well send the recovery to an early grave. Starting earlier and spacing those rate hikes out could, in theory, keep the economy in the Goldilocks zone of low inflation and low unemployment for a longer amount of time. But that's assuming the Fed doesn't start too early, in which case, its fingerprints would still be all over the murder weapon that killed the recovery.
So it all comes down to how much you trust the Fed's economic projections. If those are correct, then increasing interest rates now will have been the right move. But if they turn out to be too rosy, as has systematically been the case, then it won't. The Fed will have slowed the economy down when it didn't to. And that's part of the reason the Fed says it's not going to hike very fast or very much. It's not just about trying to help the recovery outlast Methuselah. It's about trying to make sure that, if this is a mistake, it only knocks the wind out of the recovery and doesn't send it to the ER.
The economy has already been there for seven years.