The US economy probably is nearing full employment. But the Fed should behave as though it isn’t.

Even though an economy approaching full employment (and it really does seem like the US is) means inflation is probably just around the corner, the Federal Reserve should hold back on preemptively increasing interest rates any further. The risks are asymmetric.

If the Fed holds back on increasing interest rates, and wages and inflation accelerate faster than anticipated, it won’t be a disaster. Worst case, inflation may temporarily reach 4% before the Fed gets it under control again. It certainly won’t be like the rampant inflation of the 1970s and 80s that many current policymakers still remember (and about which may be overly paranoid).

Alternatively, if the Fed continues to raise interest rates on the assumption that full employment and inflation are near, and it turns out that there is still a lot of labour market slack remaining, the US economy could be sent back into the dreaded liquidity trap. This means low economic growth, low wage growth, worsening of the debt situation, and – with monetary policy’s effectiveness severely limited in a liquidity trap – no easy way to get out.

In the US’s current situation, inflation is easier to beat than a liquidity trap.