Given all the economic data, raising interest rates is the only correct decision.
On Wednesday, the Federal Reserve will announce its decision on where to set the benchmark interest rates that affect borrowing costs throughout the economy. Practically speaking, the choice is between keeping rates where they are, between 3.5 and 3.75 percent, or raising them by 25 basis points (up to 4 percent) to begin a new round of tightening. There is only one correct decision.
Indeed, Fed Chair Kevin Warsh has already articulated the case for rate hikes in his Jackson Hole speech last month. The jobs market, for all its hiccups, is fine. Inflation is not. Cite whatever metric you please — year-over-year inflation has not once met the Fed’s target of 2 percent for the past five-and-a-half years. Annual increases in the Fed’s preferred cost index, excluding food and energy prices, are up to 3.3 percent. That means Americans’ dollars are losing value 65 percent faster than they’re supposed to.
What do interest rates have to do with inflation? General, sustained price rises are the result of the nation’s money supply outstripping the production of things people buy. Most of the money in America is in the form of bank deposits, which are created when banks lend out their reserves. When interest rates — the price of borrowing — are low, lending creates an excess of new money. Without a commensurate increase in real economic output, that new money bids up the prices of existing goods and services.
Historically, the Federal Reserve could tighten growth in the money supply by raising the interest rate on money it lends to banks, increasing the percentage of deposits that banks are legally required to keep in reserves, or by selling bonds to banks and extinguishing the money received. Today, reserve requirements are a dead letter — set at zero. And, since the 2008 financial crisis, banks now park trillions of dollars in reserves at the Fed without lending them out. Exchanging those dollars for treasuries would alter some balance sheets, but it wouldn’t affect the broader economy.
Under the current regime of ample reserves, that leaves interest rates as the “predominant tool” of monetary policy, as Kevin Warsh put it. To slow the creation of new money, it must be made more expensive.
So here we are at the Federal Reserve’s September meeting — just like any other, except far more important. At stake is nothing less than the central bank’s credibility. The argument against rate hikes has been dissolved by data. Soft inflation numbers in August might have delayed the Fed from doing the hard thing a bit longer, but inflation held firm. There is no evidence that credit conditions are overly restrictive. Even if the Fed raised rates by a full percentage point, they would still be historically below average.
Sure, there are still excuses to keep interest rates low. For instance, the president will lose whatever’s left of his ever-loving mind if his man Warsh leads a vote to raise rates. Financial markets, having developed a dependency on ultra-easy money, would also hate it. But the Federal Reserve’s job is not to placate shortsighted politicians or to keep investors’ punch bowl full. Its job is to restore price stability, and that requires higher interest rates.