As expected, the Federal Open Market Committee raised its target for the federal funds rate. The new range is 5.25-5.50 percent. The Federal Reserve’s continued efforts to bring down inflation are commendable. But there are real risks that it’s gone too far, too fast.
The most recent inflation figures help us understand how precarious the Fed’s position is. The Consumer Price Index (CPI) grew at an annualized rate of 2.16 percent in June; the Personal Consumption Expenditures Price Index (PCEPI) is not yet available for June, but grew at an annualized rate of 1.54 percent in May. That means the real (inflation-adjusted) interest rate, which is the rate that matters for economic performance, is higher than it’s been for quite some time. Adjusting using the CPI, the real interest rate is between 3.09 and 3.34 percent; using the PCEPI, it’s between 3.71 and 3.96 percent.
We need to know where the real fed funds rate is in comparison to the natural rate of interest: the price of capital compatible with full employment and sustainable growth. Current estimates suggest the natural rate of interest is between 0.5 and 1.5 percent. That’s significantly below any reasonable measure of the current real fed funds rate. Monetary policy was already restrictive; the FOMC’s decision has made it even more so.
The Fed swerved from loose to tight money in a relatively short period of time. This reflects the vagaries of discretionary policy according to bureaucratic whim. Without a firm rule to ground future policy, the FOMC has no choice but to try steering the vehicle by looking through the rear window. Although aggregate demand (i.e., total nominal spending) remains significantly elevated above its pre-pandemic trend, there are signs it is slowing. Various measures of the money supply are shrinking at 3.0 to 4.0 percent per year. The Fed’s rate hikes mean this will likely continue.
Runaway aggregate demand is bad because it causes unnecessary inflation, which imposes costs on the economy. But collapsing aggregate demand is just as bad. Falling output and rising unemployment are clearly undesirable. Rather than oscillating between boom and bust, the Fed should credibly commit to a future policy course and then deliver on that commitment.
In retrospect, the Fed’s experiment with “average inflation targeting,” which made policy even more discretionary and hence less predictable, has been a failure. It’s time for the Fed to recommit to credible price stability. The Fed needs to specify a concrete growth path for some price index—probably the PCEPI, since this is the one they use internally for policy decisions-–and then conduct policy to hit that target. There shouldn’t be any more confusion in markets about “short-run” versus “long-run” inflation targeting. Every period, there should be a specific value for the dollar’s purchasing power that the Fed commits to achieving—and if it misses, it must promise to correct the errors next time.
The Fed is supposed to be an economic stabilizer. In practice, it is much more often an economic destabilizer. If central bankers can’t figure out how to return to the (relatively) effective policy regime of the Great Moderation, the public should consider major institutional changes.