Improving productivity and better-than-expected growth make it risky to cut interest rates too much.
The economy is looking up, and that’s a challenge for the Federal Reserve. The pandemic shock prompted excessive monetary and fiscal responses, generating inflation. The Fed responded with aggressive rate hikes that reduced inflation within reach of its 2% longer-run target. Now that the economy is growing and productivity is improving, the central bank’s task is to adjust monetary policy to reflect the higher real interest rates that naturally accompany higher expected rates of return on capital.
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The Fed characterizes its current monetary policy as restrictive, meaning it will slow the economy below its 1.8% estimate of potential growth and reduce inflation to 2%. Its assessment is based on its current interest rate target of 5.25% to 5.5%, which is roughly 2.5 percentage points above the 2.8% core PCE inflation excluding food and energy. That is the highest inflation-adjusted rate since before the 2008-09 financial crisis and higher than Fed researchers’ estimates of the longer-run natural rate of interest, which they estimate to be roughly 0.5%.
Continue reading the entire piece here at The Wall Street Journal (paywall)
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Mr. Levy is a visiting scholar at the Hoover Institution and a member of the Shadow Open Market Committee.
Photo by Oleg Dubyna