The Fed Threatens To Raise Interest Rates, Which Could Be A Big Mistake

03/18/2015 02:18 pm ET | Updated Mar 18, 2015

The Federal Reserve has lost its patience with interest rates. Let's hope it doesn't lose the economy in the process.

Fed policy makers on Wednesday stopped promising to be "patient" about raising interest rates from rock-bottom levels, a sign their first rate hike could come in June. The Fed's target interest rate, known as the fed funds rate, has been roughly zero since December 2008. This rate influences borrowing costs throughout the economy. It's why the interest rate on your savings account is terrible, but it also helps explain why you can get a low-rate mortgage.

Zero-percent interest rates are basically emergency medicine, an IV drip of free money hooked up to the body economic at the worst of the financial crisis. It's safe to say the emergency is over. The economy has been growing more or less steadily since June 2009. Job growth last year was the best since the late 1990s. The Fed has already stopped some other emergency measures, like its bond-buying program known as "Quantitative Easing." Fed Chair Janet Yellen and other policy makers figure this is a safe time to raise interest rates back to something more like normal. That way, they'll be able to cut rates to help the economy when we have our next recession.

Trouble is, there's a risk the Fed might accidentally start that recession by raising rates too soon. Paul Krugman has been warning about this for a while now. Hedge-fund guru Ray Dalio of Bridgewater Associates recently warned the Fed was about to make a massive policy mistake like the one it made in 1937, triggering a "recession within the depression" by being too hasty to raise rates.

Why would the Fed take this risk? Supposedly to avoid inflation. Theoretically, a strong economy drives up hiring and demand for goods and services, which leads to higher wages and prices. This is inflation, and the Fed has been ordered by Congress not to let it get out of control.

Here's the thing, though: There's no sign inflation will get out of control. If anything, inflation has been too tame. Wage growth has been flat ever since the recession. Inflation has been running below the Fed's target of 2 percent annual growth. Fed economists have said they see no sign of inflation blowing past that target any time soon. Neither does the bond market.

The Fed showed some sympathy with that argument on Wednesday, noting it would only raise rates when it was "reasonably confident" of rising inflation. It's clearly not confident about that yet. Many in the market think the Fed will wait until at least September to raise rates.

"Just because we removed the word 'patient' from the statement doesn't mean we’re going to be impatient" about raising rates, Yellen said in a press conference.

Rate-hike enthusiasts warn that inflation is a lagging indicator, meaning it shows up long after the economy starts growing. They point out that Fed policy effects have long lags, too. If the Fed waits to see "the whites of inflation's eyes," as Krugman puts it, then it might wait too long. Inflation could get out of control.

But the Fed has spent most of the past couple of decades worrying about being too much like Japan, which has suffered from deflation -- where prices never stop falling, and people never spend money, because that thing they want to buy today will just be cheaper tomorrow.

In that light, it seems like a little out-of-control inflation could be a good thing. The Fed already knows how to stop it: By jacking up interest rates like it did in the 1980s. Getting inflation going again has proved much trickier.

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