The Federal Reserve is set to meet on Wednesday. Its preferred measure of inflation has fallen from last year’s blistering hot levels above 7% to October’s 3%, and monetary policy doves are advocating for what are known as “adjustment cuts” to offset the decline in inflation. But such cuts are not without their own, very serious risks.
What matters for the economy is not the Fed’s policy rate itself, currently set at 5.5%, but the so-called real policy rate, adjusted for inflation. If expected inflation falls and the Fed holds nominal rates steady, then the real policy rate moves up, mechanically. This process is known as passive tightening, and is the opposite of the passive loosening that occurred in 2021. The Fed held interest rates near zero far too long even as inflation shot up.
Passive changes in policy can reinforce and exacerbate economic trends, as policy throws more stimulus into an inflation trend or exerts more drag on a decelerating economy. The argument for adjustment cuts is that, without them, the Fed is conducting passive tightening it doesn’t want or need. Reductions to nominal rates would offset declines in inflation to keep real rates steady. Passive tightening would increase the odds of a sharp recession and a spike in unemployment.
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Stephen Miran is an adjunct fellow at the Manhattan Institute, co-founder of asset manager Amberwave Partners, and a former senior adviser for economic policy at the U.S. Treasury, 2020–21.
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