Should the Fed Stop Tightening?
The Federal Open Market Committee raised its federal funds rate target by 25 basis points on Wednesday. It has raised its target by 450 basis points over the last year. In December, the median FOMC member projected the target would exceed 5 percent in 2023, but some think the Fed has already done enough to bring down inflation.
Monetary policy was too loose for too long, driving up aggregate demand and causing the worst inflation in 40 years. Inflation, however, has fallen over the last couple months. In December, year-over-year growth in the core Consumer Price Index (CPI) and Personal Consumption Expenditures Price Index (PCEPI) were 5.7 percent and 4.4 percent, respectively. These may overstate how much inflation we can expect in the future. The one-month rates were 0.3 percent (3.6 percent annualized) for both the CPI and PCEPI.
Is it time for the Fed to stop tightening?
To see how close we are to “goldilocks” monetary policy, let’s look at interest rates. The current target range for the federal funds rate is 4.50 to 4.75 percent. Using the annualized core PCEPI inflation rate from the previous month as an estimate of expected inflation suggests the real (inflation-adjusted) federal funds rate is between 0.90 and 1.15 percent. How does this compare to where we “should” be?
We need an estimate for the natural rate of interest. This is the inflation-adjusted price of capital that balances its supply against demand. In economics jargon, the natural interest rate “clears” the market for capital by bringing the plans of savers and investors into alignment. Viewed another way, it’s the rate consistent with full employment of the economy’s resources. There are various estimates for the natural rate of interest—and no reason to think it is fixed over time. But most put the natural rate around 0.5 percent.
The estimates of the real federal funds rate suggest monetary policy is tight. Some would argue it is too tight. There are dangers, however, to letting up too early. Core inflation has slowed, in part, on the expectation that Fed policy will proceed as projected over the next year. If the Fed deviates from its projected course, markets may question the Fed’s resolve. And, if that happens, they could start to price in permanently higher inflation rates.
The Fed’s credibility would take a serious blow if it allowed inflation expectations to become unanchored. This would make it much costlier to whip inflation in the future. There’s no good reason to make our peace with, say, 3 percent inflation, as opposed to the historical goal of 2 percent.
The Fed should stay the course. Putting the nail in the inflationary coffin is more important than hyper-calibrating a “soft landing.” But it likely won’t be long before we’re done. If the inflation data continue to show reduced pricing pressures, the next rate hike or two could get us to where we need to be.