Analyzing the Odds of a Fed Rate Increase

These calculations, however, fail to include the potential damage if the Fed decision turns out to be the wrong one. In other words, a rate hike could end up being the right policy at the wrong time. The odds on either side of the rate decision become a lot more balanced when they are adjusted for the possible consequences of such a policy mistake.

On the one hand, having already waited too long to begin its rate hike cycle, the Fed must weigh whether delaying further risks adding to the collateral damage and unintended consequences produced by the large and prolonged disconnect between financial asset prices and economic fundamentals.

On the other hand, given how long central bankers have maintained the extraordinary policy measures of recent years, the incremental cost of waiting a little longer could appear small compared with the possible consequences of a mistake (for example, an interest rate increase that inadvertently fuels the type of instability that tightens financial conditions and spills back into the global and U.S. economy, increasing the threat of a vicious cycle).

A few months ago, I argued in favor of a rate hike as part of a comprehensive policy effort to shift markets away from an obsession about the timing of the first increase and toward a focus on the end result of what will be the "loosest tightening" cycle in the modern history of the Fed. But when I made that argument, domestic and global factors were much better aligned.

Although the Fed still has solid domestic reasons to raise rates next week, it cannot — and should not — ignore the worsening international context, given the global enmeshment of the U.S. economy and its financial system. If we adjust for the risk of a policy mistake, the odds flip to favoring Fed patience — 51 to 49. It is that close for the September policy meeting.