According to the futures market, there is a 38% chance the Federal Reserve raises rates when it meets in mid-March. If the Fed were to stand by what it has said the past several years, the odds should be much higher. But the market is used to the Fed finding reasons to put off justified rate hikes.

The Fed has consistently said it wants to see the inflation measure for Personal Consumption Expenditures (also called the PCE deflator) at 2%. We won't get an official PCE number for January until the middle of next week, but based on January's 0.6% increase in the consumer price index (CPI), it looks like the PCE index will be up 0.4% in January and 1.9% compared to a year ago. And if that's not close enough, all we need in February is a mere 0.1% monthly increase and the PCE will be over the 2% mark.



Meanwhile, the jobless rate is already 4.8%, exactly the level the consensus at the Fed thinks is the long-run average when the economy is neither "too hot" nor "too cold."

And yet the Fed's short-term interest rate target remains in a range between 0.5% and 0.75%. That's simply too low. Under normal conditions the Fed's target for short-term rates should be a little lower than the trend growth in nominal GDP – real GDP plus inflation. But in the past year nominal GDP is up 3.5% and it's up at a 3.2% annual rate in the past two years.

A gap that large between the trend growth in nominal GDP and short-term rates means there is excess liquidity in the financial system and monetary policy is too loose. No wonder inflation has been heading up and the jobless rate continues to trend down.

Moreover, the yield curve remains unusually steep, with about 180 basis points separating the yield on the 10-year Treasury Note from the Fed's short-term interest rate target, versus an average of 106 basis points since the mid-1950s. The bond market has been holding the 10-year to 30-year spread tight, because it believes long-run inflation will be contained, but clearly the market is pricing in higher short-term interest rates.