Fed Flies Blind on Monetary Policy With Rising Risk of a 6% Rate

The Federal Reserve is facing a crucial meeting later this month as policymakers grapple with an economy proven surprisingly resilient to their rapid-fire interest-rate increases, and investor anxiety about the financial system’s health remains high. Complicating matters is the fact that the Fed is flying blind when it comes to attempting to cool inflation without breaking the financial system or sending the US into a recession.

What is R*?

Known to economists as R* (pronounced “r-star”) – a guidepost of the inflation-adjusted short-term interest rate that’s neutral for the economy, neither pushing it ahead nor holding it back, the government uses it to guide its actions. If the Fed wants to slash rates during a recession to encourage borrowing and spending, it reduces rates below R*, and when it wants to slow down growth to combat inflation – as it does now – it boosts rates above that level.

However, identifying the neutral rate isn’t easy, particularly following a one-in-a-century pandemic. As Fed Chair Jerome Powell said in a congressional hearing earlier this year, “Honestly, we don’t know” where R* is currently.

The Risk of a Policy Error

One of the uncertainties surrounding interest rates is that the level appropriate for the economy isn’t necessarily the one that’s best for markets – and could run the risk of triggering disruptions in a financial system dependent on easy credit. This heightens the risk of a policy error. If officials raise rates a lot more and the neutral rate hasn’t gone up, they risk triggering a financial crisis or crashing the economy into a recession. But if the neutral rate has increased, and they don’t respond sufficiently, the US will be stuck with elevated inflation.

What’s Next?

Two closely watched estimates of the neutral rate, derived from the research by Federal Reserve Bank of New York President John Williams and his colleagues, were suspended in November 2020, acknowledging the pandemic-era difficulties. After accounting for inflation, they pegged the neutral rate at less than a half percent at that time. But suppose the neutral rate has risen by a percentage point or more due to changes in economic policy due to the pandemic and Russia’s invasion of Ukraine, including wider budget deficits and increased debt loads. In that case, the Fed’s current rate-setting doesn’t look particularly restrictive, if at all.

Some experts speculated whether the Fed’s current 4.5% to 4.75% rate target could be considered restrictive territory, given that investors anticipate inflation to average 2.8% over the next two years. However, the hunch that the neutral rate has risen is reinforced by the economy’s ability to hold up even as the Fed increased its benchmark rate from near zero a year ago, with US payrolls jumping by 311,000 in February – more than triple the pace economists see as the long-term trend.

Related Facts

• The uncertainty surrounding R* has been brought into focus due to the collapse of Silicon Valley Bank.
• If officials raise interest rates too sharply, it could undermine the stock market, increase borrowing costs, and potentially tip the economy into recession.
• The Fed is currently ramping up a bond-buying program. However, whether this would impact or contribute to inflation is unclear.

Key Takeaway

In summary, the Fed’s ongoing difficulty in determining R* creates mounting uncertainty regarding its monetary policy decisions. A policy error could cause a financial disaster, potentially leading to a higher 6% rate. Meanwhile, investors and the general public watch nervously as the Fed tries to steer the economy through uncertain times.

Conclusion

The Federal Reserve faces a significant challenge as policymakers navigate the current economic climate to bring down inflation without crashing the US into another recession. The Fed’s lack of clarity on R* is a significant concern. A misstep in its monetary policy could potentially lead to a much higher 6% rate, devastating for businesses, homeowners, and investors alike. I hope the Fed will make prudent decisions that keep the economy on the right footing.