Will the Fed Exit the Zero Rate Policy Prematurely?

I generally don’t make predictions, I infer market predictions. But this time I’ll make a specific policy prediction—and hope I am wrong. Indeed I hope the fact of my prediction will in some small way help to cause it to be wrong.

I predict the Fed will exit the zero rate policy prematurely. Here’s why:

The first zero rate trap that I am aware of was in the 1930s. The Fed tightened monetary policy prematurely, in 1936-37. We went right back into deflation.

The second example that I am aware of is Japan in the 1990s. The BOJ exited the trap prematurely in the year 2000, when the raised rates. Japan went right back into deflation, and the BOJ cut rates back to zero.

The third example that I am aware of is Japan in the 2000s. The BOJ tightened monetary policy in the year 2006, when it raised rates and reduced the base by 20%. Japan went back into deflation, and the BOJ cut rates back to zero.

The fourth example that I am aware of is the ECB in recent years. The ECB tightened policy in the spring of this year, when they raised rates. The European recovery was aborted, the debt crisis got much worse, and inflation expectations fell sharply. How long before they reverse course?

The only non-premature case I know of was in 1951, when the Fed ended the interest rate pegging program. It took a World War and a middle size war, plus a major devaluation, to get enough inflation so that the Fed could operate in a normal interest rate environment. And inflation wasn’t even very high during 1952-64.

So what’s more likely, will the Fed exit prematurely, or will we end up with high inflation? History says four-to-one it’s too early. And the reason this is almost inevitable is that big institutions follow common sense intuition. They think low rates are dangerous, and want to exit the zero rate policy as soon as they can. Low rates are problematic, but exiting too soon is even worse. Bet on a premature exit.

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