Fed Should Set a Schedule to Raise Interest Rates and Stick to It

The Fed should start raising interest rates again but only very gradually and according to a pre-set schedule.

After a disappointing first half, second half GDP growth will likely exceed 2.5 percent.
 

With job security and household balance sheets improved, consumer spending is robust but business investment has been weak—significantly owing to lower oil prices and drilling activity.
 

After falling to below $30 a barrel in January, oil has traded in the $40s since mid-April, and the number of drilling rigs has been steadily rising since mid-May. Apparently, shale producers can earn profits on new wells at these prices, and the oil patch won’t slow down growth in business investment going forward.
 

Also, the downdraft to inflation caused by falling oil prices—at the gas pump and for energy sensitive items like air fares—is essentially over.

Over the last twelve months, consumer prices—net of the volatile energy and food sectors—are up 2.2 percent. Going forward, headline inflation will be close to the Fed target of 2 percent, and that should be enough to start it worrying about too much inflation as opposed to not enough.
 

Further, with the target federal funds rate set at 0.25 to 0.50 percent, the Fed simply does not have enough room to cut rates should another recession threaten.
 

Overall, now is the time to start moving up interest rates—but not too much and not too quickly.
 

Labor markets are tighter but full employment is in the eye of the beholder.
 

The ratio of job seekers to job openings has finally fallen to pre-financial crisis levels—about 1.3. Retailers staffing for the holiday season are offering higher wages than last year. However, labor force participation among men between ages 25 to 54 remains alarming low—nearly 7 million are neither working nor looking for work.
 

Given the plethora of new benefits the Obama Administration has rolled out for them, it may take dynamite to get them off their couches. However, the Fed should not assume the economy is at full employment and these men can’t be lured back into productive lives with higher wages.
 

Also, Fed policymakers worry endlessly that keeping interest rates artificially low encourages over borrowing and asset bubbles—for example, in big city real estate and equities.
 

Residential and commercial building values are rising in the more prosperous urban centers but those have much to do with Millennials’ preference for city living and tighter land use and social regulations (requiring builders to include “affordable housing” in higher end projects) that push up new project costs.
 

Stocks are hardly overvalued given the abundance of financial capital around the world seeking yields. Businesses are using capital more efficiently these days (for example, software companies require less capital than traditional manufacturers to create new products).
 

Together, those drive up underlying enterprise values and sustainable price-earnings ratios.
 

Both the real estate and stock markets have prospered with much higher interest rates than we have now. However, it seems whenever Fed Chairwoman Yellen or one of her lieutenants musses the time is drawing near to finally raise rates, stocks take a nose dive.
 

It would be better for Yellen to simply state the economy is on track, equity prices should be able to absorb somewhat higher interest rates, and we need higher rates now so we can cut them later should a recession threaten.
 

The Fed should announce it will raise interest rates a modest one-eighth or one-sixteenth of a point at each of its policymaking meetings going forward—and stick to the schedule unless substantial changes in the economic data warrant.
 

A gradual one-half or one percentage point a year would give certainty to markets and establish confidence by economic actors, generally, that the Fed has the resolve to restore interest rates to a reasonable level.
 

Peter Morici is an economist and business professor at the University of Maryland, and a national columnist. He tweets @pmorici1

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