(Bloomberg) — The Federal Reserve is flying blind as it tries to bring down inflation without wrecking the financial system or plunging America into recession.
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Ahead of a key meeting later this month, policymakers are wrestling with an economy that has proved surprisingly resilient to their increasingly rapid interest rate hikes and an investor class that is reeling from the collapse of Silicon Valley Bank. have become jittery about the health of the financial system.
A key issue facing executives: whether the lodestar they use to guide their actions has increased and, if so, whether they should raise rates substantially in response—causing more financial turmoil in the process. Upheaval risk.
Known to economists as R*—called “R-Star”—the guidepost is the inflation-adjusted short-term interest rate that is neutral to the economy, neither pushing it forward nor holding it back. . If the Fed wants to slow growth to combat inflation — as it does now — it raises rates above that level. In a recession, it drops rates below R* to encourage companies and consumers to borrow and spend.
The trouble for the Fed is that it is not easy to sort through the ebb and flow of the economy to identify what the neutral rate is, especially after a once-in-a-century pandemic.
“Honestly, we don’t know” where R* is, Fed Chairman Jerome Powell said at a March 7 congressional hearing.
Complicating Fed officials’ thinking: The level of interest rates most appropriate for the economy is not necessarily the best for the markets – and may, in fact, risk causing disruption to a financial system that relies on easy credit. Has gone .
error risk
All the uncertainty surrounding the Fed’s stance increases the risk that it will make a policy error. If officials raise rates too much and the neutral rate hasn’t risen, they run the risk of triggering a financial crisis or plunging the economy into recession. But if R* actually rises and they don’t respond adequately, the US will be stuck with high inflation.
Two closely watched estimates of the neutral rate derived from research by Federal Reserve Bank of New York President John Williams and colleagues were suspended in November 2020 in recognition of pandemic-era difficulties. At the time, taking inflation into account, he had pegged the neutral rate at less than half a percentage point.
Investors expect inflation to average 2.8% over the next two years, which would work out to a nominal interest rate of around 3.25%. And that would clearly put the Fed’s current 4.5% to 4.75% rate target in accommodative territory.
However, some experts argue that the increase in the neutral rate by a percentage point or more is due to changes in the economy and economic policy due to the pandemic and Russia’s invasion of Ukraine – including a widening budget deficit and increased debt load.
If this is correct, then the Fed’s current rate setting does not appear to be particularly restrictive, if at all.
The rising R* has fueled fears of the economy’s carrying capacity even after the Fed raised its benchmark rate from near zero a year ago. The Labor Department reported Friday that US payrolls jumped by 311,000 in February — more than three times the pace economists see as the long-term trend.
Speaking ahead of that release, Powell said last week that, given the available data, “it’s hard to make a case that we have tightened more.”
terminal rate
He said policymakers are likely to turn their eyes to where rates will rise during the current tightening campaign when they gather to discuss monetary policy on March 21-22. In December, most Fed officials see rates rising to a range of 5.1% to 5.4%.
The Fed chairman also raised the possibility that the central bank could return to a half-percentage point rate hike at that meeting, after slashing the pace last time by a quarter point.
Diane Swonk, chief economist at KPMG LLP, said she expects a mid-point increase given the overall strength of demand. “It doesn’t look like what we’re seeing in the financial system is of a magnitude to force the Fed to step back,” she said.
Read more: SVB collapse makes Fed rate path even tougher for call
Former Treasury Secretary Lawrence Summers said on Friday there is a “quite a good chance” the Fed will eventually have to raise its benchmark closer to 6%, noting that the current setting is not much above the inflation rate – which “does not indicate Too much pressure to bring down inflation.
Implicit in their quarterly projections, Fed officials’ forecasts include an implicit estimate of the neutral rate, which compares to their predictions for longer-term policy and inflation rates.
current estimate
Based on average estimates of those variables, policymakers currently estimate the real rate by just half a percentage point. This is down sharply from 2.25% in January 2012, and reflects a decade of sluggish growth and low borrowing costs since the 2007–09 financial crisis. In contrast, financial markets were buoyant during that period.
A variety of reasons have been put forward to explain the decline. Savings were boosted as more Americans prepared for retirement and longer lives. Slow labor-force growth and low productivity gains, meanwhile, discouraged corporate investment.
Summers, a paid contributor to Bloomberg Television, has said he expects a neutral rate hike in coming years, perhaps to 1.5% to 2%, given increased government spending on defense and increased investment to make a net-change. got a boost from Zero carbon emissions.
According to Bruce Kassman, chief economist at JPMorgan Chase & Co., at least part of the decline in R* after the financial crisis was due to forces that were specific to that period and no longer apply. Households de-leveraging, banks pulling back and emerging markets pulling back. At that time the US and Europe also worked aggressively to rein in the budget deficit.
Although Kasman was hesitant to say exactly how much R* increased, he said the increase could be a percentage point or more, depending on how the economy performs in the coming months.
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