Right Thing for Wrong Reason? Why Recent Stock Declines Should Not Motivate Fed Interest Rate Moves

This post originally ran on the Wall Street Journals Think Tank blog.

According to the Federal Reserve’s now-famous “dot charts,” most members of the Fed’s board of governors and regional Fed presidents believe that short-term interest rates should be raised in 2015. But should this week’s stock market declines lead the Fed to postpone monetary tightening?

Well, no.

To be clear, tightening should almost surely be postponed past 2015—but the stock market really shouldn’t have much to do with that. For one thing, even after this week’s declines, stocks do not look particularly undervalued. One could argue that they were getting slightly overpriced in recent months (not a bubble, just on the high side).

Further, a much healthier recovery will almost inevitably involve an increase in wages and a reduction in the share of income claimed by corporate profits instead of workers. This means that economic growth would stop so disproportionately benefiting capital owners (including holders of stock) and should moderate the increase in stock prices.

Finally, focusing on the stock market one way or the other risks distracting policymakers from the important question: How much labor market slack remains in the economy? If one looks at wage growth—the most relevant measure of slack—the answer is that there is lots of slack left. Given that fiscal policy and international developments are providing no boost (or are actively dragging) on growth in the next year, it would be premature for the Fed to raise short-term rates before the labor market was back to healthy.

The dictum to not overreact to stock market changes should apply to policymakers, not just investors. And this is true even when the daily reaction to market changes happens to correspond with more measured judgments. In short, even when you end up doing the right thing, you should do it for the right reason. And trying to stem stock market declines is the wrong reason for the Fed to act.