(Bloomberg) — The Federal Reserve is flying blind as it tries to reduce inflation without breaking the financial system or plunging the US into recession.
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Ahead of a pivotal meeting later this month, policymakers are grappling with an economy that has proved surprisingly resilient to their rapid rate hikes and an investor class that has become nervous about the health of the financial system following the collapse of Silicon Valley Bank.
One key issue facing officials is whether the lodestar they use to guide their actions has increased, and if so, should they raise rates significantly in response – risking more financial turmoil in the process.
Known to economists as R* – pronounced “r-star” – the guiding principle is inflation-adjusted short-term interest rates that are neutral to the economy, neither driving nor holding back. If the Fed wants to slow growth to fight inflation – as it does now – it raises interest rates above that level. In a recession, it lowers rates below R* to encourage businesses and consumers to borrow and spend.
The problem for the Fed is that it’s not easy to sift through the ebbs and flows of the economy to determine what the neutral rate is, especially after a once-in-a-century pandemic.
“Frankly, we don’t know” where R* is, Fed Chairman Jerome Powell said at a congressional hearing on March 7.
Fed officials’ thinking gets complicated: The interest rate level best suited to the economy as a whole isn’t necessarily the one that’s best for the markets — and may even risk creating disruptions in a financial system that has become dependent on easy credit.
Error risk
All the uncertainty surrounding the Fed’s stance increases the risk of it making a policy mistake. If officials raise rates much more and neutral interest rates have not risen, they are in danger of triggering a financial crisis or plunging the economy into recession. But if R* has indeed risen and they do not react sufficiently, the US will remain stuck with high inflation.
Two closely watched neutral rate estimates derived from research by Federal Reserve Bank of New York President John Williams and his colleagues were suspended in November 2020 in recognition of the pandemic-era troubles. At the time, they set the neutral rate at less than half a percent, taking inflation into account.
With investors expecting inflation to average 2.8% over the next two years, that would equate to a nominal interest rate of around 3.25%. And it would clearly put the Fed’s current interest rate target of 4.5% to 4.75% in restrictive territory.
However, some experts argue that the neutral rate has been pushed up by a percentage point or more due to changes in the economy and economic policies brought about by the pandemic and Russia’s invasion of Ukraine — including larger budget deficits and increased debt.
If true, the Fed’s current rate setting doesn’t look particularly restrictive, if at all.
The suspicion that R* has risen is bolstered by the economy’s ability to hold up even as the Fed raised its benchmark rate from near zero a year ago. U.S. payrolls rose by 311,000 in February — more than three times the rate economists see as the long-term trend — the Labor Department reported Friday.
Prior to that release, Powell said last week that, looking at the available data, “it’s hard to show that we tightened too tightly.”
Final rate
He said policymakers will likely set their sights on where interest rates will end up during the current tightening campaign when they meet on March 21 and 22 to discuss monetary policy. In December, most Fed officials saw interest rates spike from 5.1% to 5.4%.
The Fed chairman also raised the possibility that the central bank could return to a rate hike of half a percentage point at that meeting, after backing down to a pace of a quarter point last time.
Diane Swonk, chief economist at KPMG LLP, said she expects a half-point move given overall strong demand. “It doesn’t look like what we’re seeing in the financial system is of the magnitude to force the Fed to pull out,” she said.
Read more: Fed Rate Path gets even harder to call in the wake of the SVB collapse
Former Treasury Secretary Lawrence Summers said on Friday that “there’s a pretty good chance” the Fed will eventually have to raise its benchmark by almost 6% given that the current setting is not much above the rate of inflation – which “doesn’t indicate under great pressure to bring inflation down.”
Fed officials’ forecasts, embedded in their quarterly projections, include an implicit estimate of neutral interest rates, comparing their forecasts for long-term policy and inflation rates.
Current estimate
Based on the average estimates of those variables, policymakers currently peg the real rate at only half a percentage point. That is a sharp drop from 2.25% in January 2012 and reflects a decade of slow growth and low borrowing costs following the financial crisis of 2007-2009. The financial markets, on the other hand, were buoyant during that period.
A wide variety of reasons have been put forward to explain the decline. Savings were boosted as more Americans prepared for retirement and living longer. Slowing labor force growth and subdued productivity gains, meanwhile, discouraged business investment.
Summers, a paid employee of Bloomberg Television, has said he expects the neutral rate to rise in the coming years, perhaps to 1.5% to 2%, boosted by increased government spending on defense and increased investment to support the transition to net-zero. carbon emissions.
According to Bruce Kasman, chief economist of JPMorgan Chase & Co., the fall in R* was due at least in part to forces inherent to the period that do not apply now. retreated and emerging markets declined. The US and Europe then also acted aggressively to contain budget deficits.
While Kasman was hesitant to say exactly how much R* rose by, he said the increase could be a percentage point or more depending on how the economy performs in the coming months.
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