Policy Has Tightened a Lot. Is It Enough?

This essay is also available on Medium.

An important question for monetary policymakers is, What policy stance, including the current setting of the federal funds rate, the current size and composition of the Fed's balance sheet, and the expected paths of the funds rate and balance sheet, represents "neutral"-neither stimulating nor restraining the economy?

In our Summary of Economic Projections (SEP), the participants in the Federal Open Market Committee (FOMC) estimate the longer-run level of the federal funds rate-that is, the overnight nominal interest rate that best represents neutral in the longer run, once the various shocks that are hitting the economy have passed. We cannot observe the neutral funds rate directly; we can only estimate it. My own estimate of the nominal neutral funds rate is 2.0 percent, and the range of estimates in the most recent SEP among FOMC participants is from 2.0 percent to 3.0 percent.

But is the nominal federal funds rate what really drives economic activity, and therefore, is comparing it to our estimate of its longer-run neutral level the best assessment we can make of the current stance of monetary policy?

Most economists argue that it is not nominal rates that drive economic activity, but real rates: nominal rates less inflation. And while the FOMC has now raised the funds rate by 75 basis points over the past two meetings (to 75 to 100 basis points), inflation has climbed rapidly over the course of the past year (chart 1). Some observers argue the Fed is way behind the curve because inflation has climbed faster than we have raised rates. Therefore, monetary policy has not tightened but has actually become more stimulative as inflation climbed. So we aren't simply behind the curve, they argue, we are falling even further behind.

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Is this criticism right?

No.

While I agree real rates are more important than nominal rates in driving economic activity, I believe it is long-term real rates-say 5 years, 10 years or longer-rather than overnight rates that influence business and consumer demand for credit. When businesses consider taking a loan to build a new factory, they consider their cost of capital over the life of the project to determine if the project is a good investment. Similarly, when families consider taking out a mortgage to buy a home, most are not thinking about overnight interest rates. They are considering the interest rate they will have to pay for the mortgage over the life of the loan, 10, 15 or even 30 years. Hence, in my view, long real rates are far more important than short real rates in driving economic activity, and we should look at long real rates to assess if policy is stimulating or restraining the economy. So what has happened to long real rates?

Since the FOMC began pivoting its policy stance last fall, there has been a dramatic increase in long-term real interest rates.

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Chart 2 shows that long-term real rates have risen quickly in the past several months. In fact, they have risen even faster than they fell in the spring of 2020, when the FOMC cut the federal funds rate to essentially zero and launched a massive quantitative easing program to support the economy. How is that possible given that we have only raised the funds rate by 75 basis points and haven't actually begun shrinking our balance sheet?

We are seeing the power of forward guidance: the FOMC has signaled where policy is headed in the future and markets have adjusted in anticipation of those policy moves, including both expected increases in the funds rate and decreases in the balance sheet. Because the FOMC has strong credibility with market participants, they take our forward guidance seriously, as they should.

Just before the pandemic hit, the 10-year real rate was about 0 percent, and today it has returned to about 0 percent after falling to -1 percent during the pandemic at the height of the Fed's monetary stimulus. So where are we now relative to neutral?

As I noted above, we can't directly observe the neutral nominal funds rate. The same is true for the neutral long-term real rate. We can only try to estimate it. One approach is to look at "forward" real interest rates, which allow for the effects of shocks to have passed. The following chart shows the 5-year real rate 5 years forward, which is one such proxy. You can see in it has been declining over the past 20 years (chart 3).

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We do know that neutral rates have been falling in advanced economies around the world due to factors outside the influence of monetary policy, such as demographics, technology developments and trade. I believe monetary policy was roughly at a neutral stance shortly before the pandemic. Long-term real rates have now returned to roughly that level.

So, if I think we are close to neutral now, what does that mean for monetary policy going forward?

First, at a minimum, the FOMC must follow through on the forward guidance of federal funds rate increases and balance sheet reduction that we have already signaled in order to validate the repricing that has taken place in financial markets.

Second, we will need to see whether the supply issues that have contributed to high inflation begin to unwind and/or if the economy is in a higher-pressure equilibrium. I wrote about this possibility seven weeks ago. Unfortunately, the news from the war in Ukraine and the COVID lockdowns in China are likely delaying any normalizing of supply chains. If supply constraints unwind quickly, we might only need to take policy back to neutral or go modestly above it to bring inflation back down. If they don't unwind quickly or if the economy really is in a higher-pressure equilibrium, then we will likely have to push long-term real rates to a contractionary stance to bring supply and demand into balance. The incoming data over the next several months should provide some clarity on these questions.

Finally, we will need to continue to assess where neutral is. If the economy is in fact in a higher-pressure equilibrium, that might indicate the neutral long-term real rate has increased, which would then require even higher rates to reach a contractionary stance that would bring the economy into balance.

So how do I put this all together?

The FOMC has made a dramatic pivot in the overall stance of policy over the past several months. Forward guidance and the committee's strong credibility with market participants have resulted in a withdrawal of monetary stimulus even faster than we added it in the spring of 2020. Look at how mortgage rates have sharply climbed as an indicator of how rapidly monetary policy has tightened (chart 4).

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We now need to follow through on our forward guidance, and I am confident we will. We will need to observe incoming data over the next several months to determine if fulfilling current guidance is enough to bring inflation back down or if we will need to do more. I am confident we will do what we need to do to return inflation to our 2 percent target.

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