The US Federal Reserve thinks it can take a break. As Fed officials see it, they need only sit back and wait while the monetary tightening they’ve already done gradually takes hold, slowing the economy and pushing inflation back down to the central bank’s 2% target.
They could be making a big mistake.
Officials can offer various arguments for keeping interest rates on hold, which is what markets fully expect them to do at this week’s meeting of the policy-making Federal Open Market Committee. Considerable progress has been made in restoring balance in the labor market and in bringing down inflation. Monetary policy has reached a restrictive setting. The full effects of past interest-rate increases have not yet been felt, and the recent rise in bond yields is tightening financial market conditions, negating the need for further short-term rate hikes.
I see four potentially fatal flaws in this thinking.
First, the labor market — albeit in better balance — is still too tight for the Fed to reach its 2% inflation objective. Non-farm employers have been adding about 275,000 jobs a month, far outpacing sustainable growth of the labor force. The ratio of unfilled jobs to unemployed workers remains at 1.5, well above the 1-to-1 ratio that Fed Chair Jerome Powell considers appropriate. Wage inflation remains above 4%, which — barring unexpectedly fast productivity growth — isn’t consistent with 2% overall inflation.
Second, the economy’s performance strongly suggests that monetary policy isn’t sufficiently restrictive. Gross domestic product increased at an inflation-adjusted annualized rate of 4.9% in the third quarter of 2023, far exceeding the 20-year annual average of 2.1%. Even if growth slows sharply in the fourth quarter, it’s far from certain that the economic slack will be enough to push inflation lower.
Third, monetary policy doesn’t operate with the same lags that it used to. Financial conditions move faster, anticipating changes in short-term interest rates, because Fed officials are much more transparent about monetary policy. For evidence, consider the Fed’s own financial conditions index, introduced this summer. The version with a one-year look back shows that the tightening peaked in December 2022, long before the federal funds rate reached its zenith. By the end of September, the incremental drag on the coming year’s economic activity had dissipated.
Fourth, the notion that higher long-term interest rates can substitute for additional monetary tightening depends critically upon why long-term rates have increased. Officials such as Dallas Fed President Lorie Logan and Chair Powell appear to believe that bond investors are simply demanding more yield to lend for longer (that is, term premia have increased). This would justify keeping short-term rates lower. There are, however, less benign explanations. The higher bond yields could reflect an increase in the “neutral” federal funds rate above which monetary policy becomes restrictive, or they could indicate increased inflation expectations. In either case, higher short-term rates would be needed to exert the same degree of restraint.
It’s hard to know which explanation is right. The strength of the economy supports the notion that the neutral rate is higher. Higher investment spending tied to the climate transition, as well as lower savings due to chronic fiscal deficits, point in the same direction. There’s also evidence that inflation expectations are increasing: In the University of Michigan’s Survey of Consumers, one-year inflation expectations rose to 4.2% in October from 3.2% in September, and longer-term expectations rose to 3% from 2.8%.
Fed officials are trying to achieve two goals: push inflation down to 2% and avoid a recession. This creates the risk of a mistake. If monetary policy isn’t tight enough to push inflation all the way down to 2% relatively quickly, inflation expectations might drift upward, reducing inflation-adjusted interest rates and making monetary policy less tight. If that happens, the Fed will have to act much more aggressively to get inflation under control, doing much more economic damage along the way.
In the 1980s, then Fed Chair Paul Volcker had to inflict a severe recession on the US to undo the mistakes of his predecessor Arthur Burns, who allowed inflation to get out of control in the 1970s. Powell is amply aware of the history. Nonetheless, he’s risking a repeat.
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