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The Fed wants to raise rates quickly, but may not know where to stop

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Federal Reserve Chairman Jerome Powell is accelerating monetary tightening. Its objective seems simple: bring interest rates to a “neutral” level, a parameter that does not stimulate or slow down 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 under the central bank’s feet is changing and that, after taking into account high inflation, neutrality could be higher than officials’ recent estimates.

At their meeting next month, officials are expected to approve plans to reduce their asset portfolio by $9 trillion and raise their benchmark rate by half a percentage point. They are set to follow with another half point in June.

“We’re going to raise rates and quickly get to more neutral levels, and then it will actually tighten policy if it’s appropriate, once we get there,” Powell said at a roundtable last week. . .

Key to this strategy will be estimating 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 2% target.

“The Fed only knows where neutrality is in hindsight,” said Steven Blitz, chief U.S. economist at research firm TS Lombard.

The nominal neutral rate is obtained by adding inflation to the inflation-adjusted neutral rate or real neutral rate. It is real, not nominal, rates that matter for monetary policy. Since inflation reduces the burden of debt repayment, a positive real rate is needed to create an incentive to save and a disincentive to borrow, such as for a home or business, thereby slowing economic growth and easing pressure inflationary.

Prior to the 2008 financial crisis, the nominal neutral rate was widely believed to be close to 4%, or a real neutral rate of 2% plus inflation of 2%. Over the next decade, Fed officials lowered their neutral estimate to between 2% and 3% because they believed the real neutral rate needed to keep growth and inflation steady had fallen.

Officials still think the real neutral rate is low; the question is whether inflation will eventually rise above 2%, which would mean a higher nominal neutral rate. If inflation stabilizes closer to 3%, for example, the nominal neutral rate would be closer to 3.5% than 2.5%, and the Fed might need to raise rates to 4% to really slow down. the economy.

One source of uncertainty is where the neutral actually is. It depends on where inflation sets in, based in part on factors beyond the Fed’s control.


Photo:

Frédéric J. Brown/Agence France-Presse/Getty Images

This confronts Fed officials with several questions: how quickly to get to neutral; should rates go above neutral; and where is the neutral?

Right now, most think neutrality is around 2.25% or 2.5% and rates should get there this year, at which point they can see how the economy responds. Some want to go faster, pushing rates into restrictive territory this year. Others are open to this possibility in 2023.

“I’m optimistic that we can break ground, look around, and see that we’re not necessarily that far from where we need to go,” Chicago Fed President Charles said. Evans, April 7. Last week, however, he was a little more circumspect: “We’re probably going beyond neutrality – that’s what I expected.”

A major source of uncertainty in these scenarios centers on the actual neutral position. It depends on where inflation sets in, which is partly based on factors beyond the central bank’s control, such as supply chain disruptions from the war in Ukraine and lockdowns. of Covid in China.

Federal Reserve Chairman Jerome Powell indicated on Thursday that the central bank would likely raise interest rates by half a percentage point at its May meeting. Photo: Samuel Corum/Getty Images

Blitz said the Fed could find itself today in a situation similar to 1978, when it raised rates aggressively but failed to raise real rates enough to slow the economy.

“They kept thinking, ‘Enough is enough. That’s enough.’ It turned out that was not enough,” he said. Today, “the Fed has a lot of catching up to do to tighten financial conditions if the world doesn’t come to its rescue.”

In projections released in March, most Fed officials painted a happy scenario in which they raised rates to a roughly neutral rate of around 2.75% by next year. They project that growth over the next three years will remain above its long-term rate of 1.8%, while unemployment will remain below the 4% rate, which is consistent with stable prices.

But these projections assume that inflation, now above 5% based on the Fed’s preferred index, will return to an underlying long-term trend rate of 2% without rising unemployment, which has always been rare.

“The odds of doing what they predicted in March are low, maybe 25%,” said Donald Kohn, a former Fed vice chairman.

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John Roberts, a former Fed economist who retired last year, presented two other scenarios in a recent analysis. Under the first, the Fed is raising rates to nearly 2.5% this year and 4.25% next year, bringing inflation down to 2.5% by 2025. the unemployment rate on a scale that has only occurred during recessions.

In the other, high inflation through 2022 changes underlying consumer psychology, driving core inflation higher, and the Fed fails to raise rates enough to counter that, leaving the inflation consistently above 3% for the rest of the decade.

The bond market has faced a sharp selloff over the past two months, pushing yields higher as the Fed promises tougher policy. It could be another blow if central bank officials publicly conclude that interest rates must be even higher than currently expected in 2023.

Write to Nick Timiraos at [email protected]

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