This article first appeared in Forum, The Edge Malaysia Weekly, on October 5 - 11, 2015.

THE US Federal Reserve conspicuously failed to raise interest rates in September. It did everything else it was supposed to do. The Fed signalled that quantitative policy would not change. The Fed guided that future rate changes would be slower than normal. It is just that somewhere in the process the Fed forgot to raise interest rates.

The failure to raise rates was bad enough, but the language used to communicate the “logic” of its decision was even more troubling. The Fed implied that market volatility had helped to prevent a rate increase. This is a frightening reason, implying as it does that the Fed is now held hostage by the financial markets.

If we take this to the extreme, the idea that an equity trader in Shanghai could press the wrong button on their computer and as a result of the ensuing market volatility could cause economists to have to change their forecasts for US interest rates inverts both logic and the natural order of things. Markets should not dictate to economists, ever. Economists should lead, and markets should follow at a respectful, reverential distance.

Thankfully, a number of Fed officials have subsequently come out with comments that suggest they are at least attempting to resist the thrall of the markets. Eventually, even Fed chair Janet Yellen admitted that she, too, wanted to raise rates this year. Interestingly, her call for higher rates came in the middle of a speech about inflation.

Yellen's comments on inflation were not brief. Economists were treated to an erudite discourse on inflation. Unfortunately, most of this was lost in the media coverage. The modern trend for “sound-bite economics” tends to result in superficial analysis. Reporting of the Fed chairman’s comments focused on her support for a rate increase this year; the inflation comments were generally overlooked. This is a pity, because what Yellen was talking about matters.

Yellen seems convinced that inflation will continue to move towards the Fed's target of 2%. That matters to markets because the Fed will raise rates as long as it believes inflation is heading towards its target — it does not have to be at its target.

Yellen suggested that short-term noise in import prices should be ignored. That matters to markets because it downplays the role of the dollar and foreign markets in determining US monetary and quantitative policies.

Finally, Yellen suggested that the recent dip in inflation below the 2% target of the Fed was temporary. This matters to markets because it suggests the Fed is not concerned about deflation risks.

The next stage in the US economic cycle is for headline inflation to leap up. This is a global issue. The impact of oil prices has been to reduce headline inflation in most major economies since last October. That impact is going to fade, and fade fast, from the headline consumer price data.

Essentially, headline inflation rates are likely to converge with core inflation rates (which exclude some energy prices) as the oil effect disappears. This implies that headline inflation will rise 0.8% or more in most major economies. Indeed, core inflation could also rise, because core inflation rates do include some energy (it is just buried away in things like air fares and transport costs).

Although most investors know that the oil effect is going to disappear, the fact that each month’s headline inflation number comes in low does have an impact on market psychology. Investors still seem to have a disinflation bias to their thinking. However, as headline inflation rates suddenly jump up, between October and January, this disinflation bias should fade away.

While it seems unlikely that investors will start to look for high inflation, and while it is unlikely that inflation is to rise too rapidly, a US headline inflation number that is closer to 2% is likely to mean that investors stop looking for downside risks to inflation when data is released or policymakers speak.

This move will also give the Fed the opportunity to free itself from the perceived influence of financial markets, and allow it to exert its independence properly. Although the rise in inflation is very predictable, it will allow Yellen to point to a near 2% inflation reality and say “that is why we are raising interest rates”. This carries more conviction than Yellen pointing to a forecast of rising inflation as the justification for tightening.

I believe the US Federal Reserve erred in its September policy meeting, in particular in seeming to give financial markets power over its decisions.

However, the coming increase in inflation and the reversal of markets’ disinflation psychology will restore the Fed’s freedom of action. The coming inflation increase means now is an excellent time to join the campaign. It is time to #FreeTheFed.

Paul Donovan is senior global economist at UBS Investment Bank. His latest book The Truth About Inflation was published by Routledge in April 2015. Visit www.ubs.com/pauldonovan for more research.

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