The Case Against a Mega 1% Federal Reserve Rate Increase

If the consumer price index report for August that showed inflation remains much hotter than forecast was not enough of a shocker, then talk that the Federal Reserve needs to raise interest rates in even bigger chunks starting with its meeting next week surely is.

The idea that the central bank must lift its target for the overnight rate between banks by 100 basis points — something it hasn’t done since the 1980s — after increasing it by 75 basis points in both June and July is not some fringe notion. Money market traders are pricing in a not insignificant 33% chance that it will happen. The thinking is that the Fed needs to get radical if it truly wants to get control of inflation, which rose 8.3% in August from a year earlier.

There are two primary reasons an increase of such magnitude would be a bad idea. The first and most obvious is that it would signal the Fed is in panic mode, which is not a good look for any central bank, let alone the most important one in the world. Risk premiums might blow out to compensate traders for the heightened risk of uncertainty around monetary policy. That would upend credit markets, the lifeblood of the financial system. This is a Fed that has long sought to ensure the smooth functioning of financial markets by preparing them for what’s coming, when it’s coming and by how much well in advance. That’s what forward guidance is all about.