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Yellen Cries Wolf

The Fed chairwoman tries to convince the market that a rate rise is coming, but investors aren’t listening.

What if the Federal Reserve declared its intention to raise interest rates, but no one believed it?

Fed Chairwoman Janet Yellen came close to such a declaration on Friday, saying at the Jackson Hole summit in Wyoming that “the case for an increase in the federal-funds rate has strengthened in recent months.” This language is about as strong as a central banker could be to warn of a coming move.

For the first two hours after the speech, stocks moved higher and bond yields fell slightly, a reaction that seems to say, prove it.

It wasn’t until her ally, Fed Vice Chairman Stanley Fischer, said in a CNBC interview that Ms. Yellen’s comments were consistent with two rate increases this year, something almost no one expects, that markets reversed.

Even then, the reaction was subdued. The S&P 500 stock index ended the day down slightly, and yields on 10-year Treasury notes inched up by five one-hundredths of a percentage point.

The Fed is suffering from a credibility problem, and it has itself partly to blame. Over the past couple of years, it has repeatedly signaled impending tightening, only to back away. Most recently in April, it signaled that a June increase was possible by dropping references to global and financial risks. But a weak employment report in May derailed its plans.

The projections for future rate levels by Federal Reserve Open Market Committee members, shown in the now infamous “dot plots,” have been consistently wrong, reflecting too much optimism about economic growth.

Even as she signaled higher rates, Ms. Yellen presented a chart that showed that rates could be anywhere from just above zero to 4.5% by the end of 2018.

Still, investors would be unwise to dismiss the possibility of a rate increase. The case for monetary tightening has strengthened. As Ms. Yellen noted, job gains have averaged a solid 190,000 over the last three months, showing May’s weak reading to be an aberration.

There are also new signs of rising wage pressures. U.S. stocks are at all-time highs. And global markets have quickly bounced back from the shock of Brexit, suggesting that external risks to the U.S. economic outlook may have been overplayed.

The Fed may have cried wolf a few too many times recently. But investors should remember that in the original parable, the wolf did show up eventually. The time to start preparing for higher rates is now.

Write to Aaron Back at aaron.back@wsj.com

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