Much as the world aspires to normal after two wrenching years of a pandemic, the Federal Reserve is reaching for a neutral monetary policy that will arrest inflation without triggering a recession. But finding neutral on the economy’s gearshift may not be any easier than defining normal these days.
Monetary policy is much less precise than we’d like to believe. We can't even be sure what a neutral rate would be. People would probably be disturbed if they knew how poorly economists understand how changing interest rates feeds through markets and ultimately affects inflation and unemployment.
We do know that high inflation is here and it's not going away anytime soon. Prices rose 7.9% last month on an annual basis, and given Russia's war on Ukraine and shutdowns in China, it may go higher.
The Fed responded by raising its policy rate by 25 basis points on Wednesday and signaling more increases over the course of the year. Maybe it will be 50 points next time. Naturally everyone wonders exactly how high rates might go, with the prime worry being the Fed will overshoot neutral and cause a recession. Of course, the Fed has no intention of increasing rates into recessionary territory (at least not yet). The bad news is that it may be too late for neutral if we want to curb inflation.
Once inflation gets going it’s hard to stop. Economists expect higher wages this year in response to inflation, and this risks pushing prices up further in a spiral that will require more aggressive policy.
But what would that look like? Monetary policy has three modes: accommodative, neutral and contractionary. You can categorize which mode the Fed is in based on how high its policy rate is compared with the natural rate of interest. Or rather, where they'd be without any government interference—a rate now assumed to be 2% or 3%.
The Fed is in accommodative mode when it sets the target interest rate below the natural rate, which is where we are now, even after this week's rate hike, with a target rate between 0.25% and 0.5%. In accommodative mode the Fed is trying to juice the economy by lowering the cost of capital. This is presumed to boost the labor market, but it may also increase inflation. Neutral matches the natural rate. When the Fed is in neutral it's not boosting the economy, but not pulling back on it, either.
To control an overheated economy the Fed may move into contractionary mode, which is raising the policy rate above the natural rate, which means it’s more expensive for banks to get capital, the economy shrinks and inflation falls. Right now, the Fed claims it only wants to go to neutral.
But even neutral feels like a big deal because the Fed has mostly been in accommodative mode since the financial crisis (except for maybe a month or two). Only in the last few months has Fed Chairman Jerome Powell said he would consider going a bit higher if inflation doesn't cool.
In theory, when you’re in neutral you’ll have slow, steady, predictable inflation. But that assumes inflation is contained to begin with. Neutral does nothing to fight inflation. So with its current strategy, the Fed appears to be hoping that inflation will go away on its own if it stops accommodating and the supply chain and oil market work out their kinks.