Much as expected, the Federal Reserve has raised its policy interest rate by half a percentage point and announced an accelerated schedule for reducing its holdings of financial assets. This is a faster pace of tightening than the central bank intended after its previous meeting in March. With inflation at 5.2 percent on the Fed’s preferred measure and little sign yet that it’s about to subside, this adjustment makes sense. But it leaves some questions unanswered.
Federal Reserve Board Chairman Jerome Powell’s statement that the Fed was working toward getting rates back to neutral invites confusion by suggesting to investors that the Fed has in mind an arbitrary end point for interest rates. It doesn’t – or, anyway, shouldn’t. Brendan Smialowski/Pool via Associated Press
The Fed’s task under current conditions is extraordinarily difficult. After the pandemic slammed output in 2020, the economy recovered strongly – too strongly, as it turned out, thanks to an unduly powerful fiscal stimulus enacted by Congress. COVID’s effects were still complicating economic policy when Russia invaded Ukraine, causing the U.S. and its allies to impose brutal sanctions that disrupted energy and commodity markets all over again. Now China’s initial success in containing the virus has given way to massive new shutdowns, putting yet more stress on global supply chains.
Faced with such turbulence, monetary policy can only do so much. Holding the economy on a steady path of non-inflationary growth is all but impossible. The most the Fed can do is avoid making the problem worse with unforced policy errors.
To be sure, some critics accuse it of doing just that, by keeping interest rates close to zero for far too long. The Fed has admitted that it should’ve started tightening sooner, and a few economists such as former Treasury Secretary Larry Summers began urging this last year. Still, only recently has it become clear that the rise in inflation is more persistent than most analysts first thought – and the risk of tipping the economy into recession by tightening too abruptly remains. Policy needs to strike a balance, and for the moment it looks about right.
However, the Fed could improve its messaging in two main ways. First, it needs to keep underlining that it will adjust policy as circumstances require. This bears repetition because its pre-COVID approach emphasized (for good reason) a commitment to keep interest rates close to zero even after inflation had moved back to its target of 2 percent. What worked back then no longer does. Investors should be left in no doubt that this earlier approach has been ditched.
Relatedly, the Fed ought to clarify its position on the “normal” or “neutral” rate of interest, which is rapidly becoming investors’ new fixation. Economists have estimated this ever-shifting rate to be roughly half a percentage point in real terms, meaning 2.5 percent once inflation is back on target – but they can’t be sure about that, much less about what “neutral” should mean as prices fluctuate. When asked about it Wednesday, Chairman Jerome Powell rightly agreed that the idea often gives rise to “false precision.” Yet he also said (more than once) that the Fed was indeed working toward getting rates back to neutral.
This invites confusion by suggesting to investors that the Fed has in mind an arbitrary end point for interest rates. It doesn’t – or, anyway, shouldn’t. Rates should be adjusted to keep demand on track. Changing conditions will dictate what that requires.
The Fed will need to be lucky as well as skillful to bring inflation back to target without causing a recession. But its job would be a bit easier if it directed investors’ attention away from imaginary targets and toward what’s actually happening to the economy.
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