What is the Federal Reserve Thinking?

Fed projections and much ado about nothing

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Last week the Federal Reserve released updated projections for real GDP growth, inflation, unemployment, and the federal funds rate for the next few years. What was most notable was the Federal Reserve’s projection for its preferred measure of communicating the stance of monetary policy (the federal funds rate). The Federal Reserve’s projection for the federal funds rate in 2024 is 4.6 percent. This is not only lower than the Fed’s current target range for the federal funds rate (5.25 to 5.5 percent), but also lower than the Fed’s September projection of 5.1 percent.

In response, market commentary was wildly speculative about what this change in projections meant about monetary policy. Some speculated that this was an implicit admission by the Federal Reserve that fiscal dominance had taken hold and that they had no choice but to start lowering rates. Others suggested that it was a sign that the Fed had capitulated and admitted defeat in its “battle” with inflation. Some said the Jerome Powell wanted to be Paul Volcker, but revealed himself to be Arthur Burns instead.

In reality, if you understand the dominant view of monetary policy among central bankers, you were not surprised at all by the update in projections.

Conventional Wisdom

A common way of thinking about monetary policy is in terms of the “natural” rate of interest. This is an idea that dates back to Swedish economist Knut Wicksell. The natural rate can be thought of as the interest rate that would exist in a frictionless, competitive market. The common view is that when the central bank’s policy interest rate is below the natural rate, the inflation rate will rise. When the central bank’s policy interest rate is above the natural rate, the inflation rate will decline. When the central bank’s policy interest rate is equal to the natural rate, the inflation rate will remain constant.

With that as the background, let’s think about how this would apply to the recent experience of high inflation. According to this view, the high (and rising) rates of inflation is an indication that the policy interest rate is too low. However, to bring down inflation, it is not sufficient to merely raise the policy rate to the natural rate. The central bank needs to raise the policy rate above the natural rate so that the inflation rate will decline. Then, as the inflation rate declines toward the central bank’s target inflation rate, the central bank needs to start lowering the policy rate toward the natural rate.

What this implies is that, according to this view of monetary policy, a disinflationary policy requires that the central bank “overshoots” the natural rate of interest and then gradually brings the policy rate back down to the natural rate as inflation declines.

What we have seen recently is that the inflation rate has been declining. Thus, if you understand this view of monetary policy, it should come as no surprise that the Federal Reserve would start to talk about lowering interest rates.

Should We Declare Victory from Recession?

The hyperbole in response to the release of the Federal Reserve’s projections was not limited to those critical of the Fed. Some of the positive responses were equally hyperbolic in declaring victory. Many viewed the declining inflation rate in conjunction with projections of a lower federal funds rate as a sign that the Federal Reserve has successfully lowered inflation without causing a recession.

It is possible that this is true. However, that sentiment might be premature.

One difficulty with using the natural rate as a guide to policy is that no one knows the natural rate — or even if such a thing actually exists. As I’ve discussed before, concepts like a natural rate of interest or the natural rate of unemployment are useful modeling devices. They are used to help organize our thinking about how policy is conducted and the limitations of policy. Within this conventional framework, policymakers are expected to draw inferences about the difference between the policy interest rate and the natural interest rate from the behavior of inflation. If inflation is rising and above its target, this is an indication that the policy rate is “too low.” If inflation is declining and below its target, this is an indication that the policy rate is “too high.” If inflation is relatively constant, this is a sign that the policy rate is approximately equal to the natural rate.

Nonetheless, since the natural rate cannot be directly observed, this means that policymakers do not know if the rate is “too high”, “too low”, or “just right” independent of what is observed the data on inflation and inflation expectations. This makes the central bank susceptible to lowering the policy rate too early or keeping the policy rate too high. In the event that the central bank lowers the policy rate too early or is wrong about the natural rate of interest, it is possible that inflation remains above the 2 percent target or even starts to rise again. If the central bank keeps the policy rate too high for too long, the inflation rate will fall below the central bank’s target. Contractionary monetary policy of that type is likely to result in a recession.

This issue is further exacerbated by the fact that Federal Reserve also might be concerned about its credibility. Not only does the public have experience recently with historically high rates of inflation, but the public also has a memory of Federal Reserve policymakers assuring everyone that inflation would be transitory and that interest rates would likely remain low for a long time. If members of the Federal Open Market Committee are concerned about the credibility of the Fed, they might be hesitant to start lowering rates until inflation has been brought down to its target. If so, they might risk over-tightening monetary policy and inducing a recession.

Finally, there is an alternative view of monetary policy that stresses the importance of deviations between policy rates and the natural rate. Austrian Business Cycle Theory suggests that deviations between the policy rate and the natural rate do not simply cause changes in inflation, but also lead to distortions in the structure of production. When the policy interest rate is “too low,” this tends to result in investment projects that are not sustainable or profitable when the the market interest rate rises. It is only after the policy interest rate rises that this malinvestment is realized.

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In short, the commentary surrounding last week’s release of the latest Fed projections was much ado about nothing. Contrary to the hyperbole that the Fed had capitulated, the updated projections were perfectly predictable if one understands the conventional wisdom on monetary policy. Similarly, while it would be great if the Federal Reserve was able to reduce inflation without a recession (a position that all the Phillips Curve appreciators deny is possible, by the way), the victory laps over the lack of recession to this point are a bit premature.