Many economists doubt this will be enough. Once inflation gets high and stays around long enough, it influences expectations. In the past it’s taken contractionary policy to slow the economy down, revise expectations and lower inflation.
So how worried should we be about the Fed causing a recession if it does decide to go above neutral? There is no magic interest rate where we risk a recession. A very high policy rate, like 12%, would probably do it, but it's unclear if 4% or 5% would. That was the policy rate range for many years and there was no recession.
But these are different times; we think the natural rate is lower now. Expectations about the future play a big role in inflation and hiring, but we don't really know how those expectations are formed or how to measure their impact. After all, the Fed was in accommodative mode for nearly 15 years and inflation barely topped 2%.
It could be that going to neutral will be enough. Or perhaps 50 basis points above neutral will convince markets the Fed is serious about inflation and it will fall—though the Fed’s behavior so far doesn't suggest it has or deserves much credibility.
What is potentially more worrying than a recession is financial instability. Members of the Fed Board don't have much experience in financial markets, let alone fixed income markets, and rates have been very low for a very long time. Low-risk assets, which are influenced by the policy rate, are systemically important. They determine how much banks lend to each other, the cost of collateral, and how assets are priced. Going well above zero may be a shock to markets and it could cause big dislocations. Even if inflation settles to 4% and the Fed decides it can live with that, this will mean higher interest rates, and that may be unsettling for markets that after so many years are now built for zero rates.
This may be why the Fed is hoping some firm talk and neutral policy will be enough to tame inflation without harming employment. But monetary policy, as in life, is all about trade-offs. You can rarely have it both ways, and the Fed will need to do some damage to get prices under control. That may not mean a recession, but it could mean lower asset prices, lower real wages and more uncertainty ahead for the economy.
Allison Schrager is a Bloomberg Opinion columnist. She is a senior fellow at the Manhattan Institute and author of An Economist Walks Into a Brothel: And Other Unexpected Places to Understand Risk.