Federal Reserve Chairman Jerome Powell shifts monetary tightening to a higher gear. His goal is straightforward – raise interest rates to “neutral”, a setting that neither encourages nor slows growth.
But there is a catch: Even in normal times, no one knows where this theoretical level is. And these are not normal times. There are good reasons to believe that the ground beneath the central bank’s feet is moving and that neutral, after taking into account rising inflation, may be higher than officials’ latest estimates.
At their meeting next month, officials are set to approve plans to shrink their $ 9 trillion asset portfolio and raise their benchmark rate by half a percentage point. They are ready to follow with another half point in June.
“We want to raise interest rates and quickly get to levels that are more neutral, and then it’s actually a tightening of policy if it turns out to be appropriate when we get there,” Mr Powell said during a panel discussion last week. week.
The key to that strategy will be estimates of the neutral interest rate, a monetary nirvana that balances supply and demand when unemployment is low, the economy is growing steadily, and inflation is stable around the Fed’s target of 2%.
“The Fed only knows how neutral it is in hindsight,” said Steven Blitz, chief economist at research firm TS Lombard.
The nominal neutral interest rate is obtained by adding inflation to the inflation-adjusted or real-neutral interest rate. It is real, not nominal, interest rates that have an impact on monetary policy. Because inflation reduces the burden of repaying debt, a positive real interest rate is necessary to create an incentive to save and a deterrent to borrow, e.g. to a home or a business, thereby slowing economic growth and cooling inflationary pressures.
Before the financial crisis in 2008, the nominal neutral rate was broadly estimated to be close to 4% – a real neutral rate of 2% plus inflation of 2%. Over the following decade, Fed officials lowered their estimates of neutral to between 2% and 3% because they felt the real neutral rate needed to keep both growth and inflation stable had fallen.
Officials still believe the real neutral rate is low; The question is whether inflation will end above 2%, which will mean a higher nominal neutral interest rate. If inflation e.g. falling closer to 3%, the nominal neutral interest rate will be closer to 3.5% than 2.5%, and the Fed may have to raise interest rates to 4% to actually slow the economy.
This confronts Fed officials with several questions: How fast does one get to neutral; the prices must go above neutral; and where is neutral?
At present, most people believe that neutral is around 2.25% or 2.5%, and rates should reach that point this year, after which they can see how the economy responds. Some want to go faster and push rates into a restrictive area this year. Others are open to that opportunity in 2023.
“I’m optimistic that we can get to neutral, look around, and find that we’re not necessarily that far from where we’re going,” Chicago Fed President Charles Evans said on April 7. Last week, however, he was a little more thoughtful: “Probably we go beyond the neutral – that’s my expectation.”
A significant source of uncertainty in these scenarios is centered on how neutral really is. It depends on where inflation settles, which is partly based on factors beyond the central bank’s control, such as supply chain disruptions from the war in Ukraine and Covid lockdowns in China.
Mr. Blitz said the Fed today may be in a situation similar to 1978, when it raised interest rates aggressively, but failed to push real interest rates up enough to slow the economy.
“They kept thinking, ‘This is enough. This is enough.’ It kept proving that it was not enough, “he said.” Today, the Fed has a lot to gain from tightening financial conditions if the world does not come to its rescue. “
In projections released in March, most Fed officials charted a cheerful scenario in which they raised interest rates to a fairly neutral rate of around 2.75% next year. They expected growth to remain above its 1.8% long-term rate over the next three years, while unemployment remains below the 4% rate that officials estimate is consistent with stable prices.
However, these projections assume that inflation, now above 5% based on the Fed’s preferred index, will return to a long-term underlying trend rate of 2% without higher unemployment, which has historically been rare.
“The odds of doing what they expected in March are small – maybe 25%,” said Donald Kohn, a former vice president of the Fed.
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John Roberts, a former Fed economist who retired last year, presented two other scenarios in a recent analysis. Taken together, the Fed raises interest rates to almost 2.5% this year and to 4.25% next year, bringing inflation down to 2.5% by 2025. That would push up the unemployment rate to orders of magnitude that have only occurred during recessions.
In the second, high inflation through 2022 will change underlying consumer psychology, causing underlying inflation to rise and the Fed failing to raise interest rates sufficiently to counteract this, leaving inflation persistently above 3% for the rest of the decade.
The bond market has faced a brutal sell-off over the past two months, pushing up interest rates sharply as the Fed promises a tighter policy. It could be another blow if central bank officials publicly conclude that interest rates should go even higher than expected in 2023.
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