The Fed Does Nothing But Guess About Rates

By Allison Schrager

Just as the world aspires to normality after two harrowing years of the pandemic, the Federal Reserve seeks a neutral monetary policy that will stop inflation without triggering a recession. But finding neutral on the economy’s shift lever can be as difficult as defining normalcy these days.

Monetary policy is much less precise than we would like to believe. We can’t even be sure what a neutral rate would be. People would probably be perturbed if they knew how poorly economists understand how changes in interest rates are transmitted to markets and ultimately affect inflation and unemployment.

What we do know is that high inflation is here and it’s not going to go away anytime soon. Prices rose 7.9% last month on an annual basis, and given Russia’s war against Ukraine and China’s lockdowns, they may continue to rise.

The Fed responded by raising its policy rate by 25 basis points on Wednesday and targeting more hikes later in the year. Maybe next time it’s 50 points. Naturally, everyone is wondering how far rates can go, with the main concern being that the Fed overshoots neutral and triggers a recession.

Of course the fed it has no intention of raising rates into recession territory (at least not yet). The bad news is that it may be too late for neutrality if we want to curb inflation.

Once inflation gets going, it’s hard to stop. Economists expect wages to rise this year in response to inflation, and this risks driving prices higher in a spiral that will require more aggressive policy.

But what would that be like? Monetary policy has three modalities: accommodative, neutral and contractionary. You can classify the mode the Federal Reserve is in based on how high its policy rate is compared to the natural rate of interest. Or rather, where would they be without any interference from the government, a rate that is now supposed to be 2% or 3%.

The fed you are in dovish mode when you set the target interest rate below the natural rate, which is where we are now, even after this week’s rate hike, with a target rate of between 0.25% and 0.5%.

In accommodating mode, the fed tries to stimulate the economy by reducing the cost of capital. This is supposed to give a boost to the labor market, but it can also increase inflation. The neutral mode coincides with the natural rate. When the Federal Reserve it is in neutral mode, it does not stimulate the economy, but it does not slow it down either.

To control an overheated economy, the fed it can go into contractionary mode, which is to raise the policy rate above the natural rate, which means it’s more expensive for banks to raise capital, the economy contracts, and inflation falls. At this time, the fed he claims he just wants to get to neutral.

But even neutral seems like a big deal because the Fed has been mostly in dovish mode since the financial crisis (except maybe a month or two). In the last few months alone, the president of the fedJerome Powell said he would consider raising rates a bit more if inflation doesn’t cool off.

In theory, when policy is neutral, inflation will be slow, steady, and predictable. But that assumes inflation is contained to begin with. Neutral policy does nothing to combat inflation. So, with your current strategy, the fed it seems to expect inflation to go away on its own if it stops accommodating and the supply chain and oil market work out their problems.

Many economists doubt that this is enough. Once inflation rises and lasts long enough, it influences expectations. In the past, a contractionary policy has been necessary to slow down the economy, revise expectations and reduce inflation.

So how concerned should we be that the Federal Reserve will trigger a recession if it decides to overshoot the neutral rate? There is no magic interest rate at which we risk a recession. A very high policy rate, like 12%, would probably do it, but it’s not clear whether 4% or 5% would. That was the interest rate range for many years and there was no recession.

But these are different times; we think the natural rate is lower now. Expectations about the future play a big role in inflation and hiring, but we don’t really know how those expectations are formed or how to measure their impact. After all, the fed it was in accommodative mode for almost 15 years and inflation barely exceeded 2%.

It could be that reaching neutrality is enough. Or perhaps 50 basis points above a neutral rate will convince the markets that the Fed is serious about inflation and that it will fall, even though the behavior of the fed so far it does not suggest that it has or deserves much credibility.

What is potentially more worrying than a recession is financial instability. The members of the Board of the fed they don’t have much experience in financial markets, let alone fixed income, and rates have been very low for a long time. Low-risk assets, which are influenced by the policy rate, are systemically important. They determine how much banks lend to each other, the cost of collateral, and the price of assets.

Rising much above zero can be a shock to the markets and could cause major dislocations. Even if inflation stabilizes at 4% and the Fed decides it can live with that, it will mean higher interest rates, and that may be unsettling for markets that after so many years are now built for zero rates.

This may be the reason why the fed he hopes that a firm speech and a neutral policy will be enough to control inflation without damaging employment. But monetary policy, like life, is a matter of compromise. You can rarely have both, and the fed will have to do some damage to control prices. That may not mean a recession, but it could mean lower asset prices, lower real wages, and more uncertainty for the economy.