As stocks lurch, Fed ponders twist of the dial

Should the Federal Reserve raise U.S. interest rates at its September meeting? That question rings louder than ever amid a worldwide rout in stocks that has rattled investors and heightened concerns about slowing global growth.

A premature move by policymakers to tighten monetary policy risks shutting down one of the engines that has kept the U.S. economic recovery on track even as other major regions, notably Asia, sputter. Wait too long, as the Fed's "hawks" argue, and the economy could quickly overheat, pushing up inflation and tipping the economy back into recession.

Some forecasters are sticking with earlier predictions that the Federal Open Market Committee (FOMC) -- the central bank's rate-setting panel -- will boost rates at its Sept. 16-17 meeting. But others say the plunge in financial markets around the world, including in the U.S. and China, could push back the central bank's timetable.

"Although we continue to see economic activity in the U.s. as solid and justifying modest rate hikes, we believe the Federal Reserve is unlikely to begin a hiking cycle in this environment for fear that such a move may further destabilize markets," analysts with Barclays Capital said in a Monday note. "Instead, we believe the FOMC will delay the start of the rate hike cycle beyond September as a means to offset tighter financial conditions while it evaluates the effect of recent volatility."

So should the Fed pull the trigger? It's a tough question. Answering it is complicated by the long lag between when monetary policy is implemented and when it takes effect, which forces the Fed to make policy decisions based on uncertain forecasts of the future economy.

The main issue is whether the U.S. economy's lackluster performance -- most forecasters expect gross domestic product of less than 3 percent -- is due to temporary factors that will soon fade or more permanent effects arising from demographic and technological changes that will growth for years.

If there were no lags in monetary policy, if policy took effect immediately, the Fed could wait and see if the the modest growth persists or a more robust recovery appears and implement policy accordingly. But it typically takes six to 18 months for changes in monetary policy to take effect.

As a result, many Fed members who believe the factors holding back the economy are temporary and beginning to ease favor increases in the target interest rate fairly soon, even as the direction of the economy is not yet clearly known.

Those who oppose rate increases cite three reasons. First, inflation is below the Fed's 2 percent target and unemployment remains elevated, both of which point to maintaining low rates.

Second, the potential costs of increasing rates too soon, which could cause the job market to remain below the full employment level for much longer than if rates remained low, are much larger than the costs of inflation that could arise if rates are raised too late.

Why? Because it's much easier for the Fed to slow down an overheated economy where inflation is surging than it is to stimulate the economy out of a recession. Also, unlike inflation, unemployment tends to hurt the most vulnerable members of society.

If the Fed makes a mistake, it should be to wait too long to raise rates rather than increasing them too soon, those cautioning against an immediate lift-off argue. This means the Fed should be patient in the face of economic uncertainty.

Third, there is evidence that the economy is entering a period of extended stagnation due to changes in demographic and technological factors. This possibility, known as the "secular stagnation" thesis and promoted most forcefully by former U.S. Treasury Secretary Larry Summers, is based on the idea that factors such as the aging of the U.S. population and falling productivity will lead to an excess of saving over investment, a situation that is normally cured by falling interest rates.

Yet with interest rates already as low as they can go, this mechanism is broken, and the consequence is a level of aggregate demand that is insufficient to support full employment. In such a situation, the last thing you want to do is raise interest rates and make the situation worse.

There is no way to know for sure which of these views is correct -- only time will tell.

A mistake that causes elevated inflation is easy to spot, and it's easy to blame the inflation on the Fed. A mistake in the other direction that causes elevated unemployment is much harder to observe due to disagreement about what constitutes full employment, and it's much easier to blame factors other than a Fed mistake for the problem.

But the fact that it's much easier for the Fed to escape the blame for high unemployment is no reason to risk the relatively high costs of such an outcome, those who oppose a near-term rate hike say. It's the economic cost of a mistake that is important, not whether it will be blamed, and the Fed's independence is supposed to insulate it against such concerns.