Last week, Federal Reserve Chairman Jerome Powell seemed to announce a new attitude toward the trajectory of short-term interest rates. Whereas the chairman had described rates as far from neutral as recently as October, now he’s characterized the current 2 to 2.25 percent target range as “just below the broad range of estimates of the level that would be neutral for the economy—that is, neither speeding up nor slowing down growth." Does his shift in tone signal the end of the hiking cycle?
When the Fed began normalizing rates three years ago, few questioned the consensus view that monetary policy was overly accommodative, and rates would need to rise steadily to return to their natural equilibrium. Overnight rates were resting at zero percent, and two rounds of unconventional quantitative easing had suppressed real long-term interest rates as well, pushing borrowing costs well below equilibrium.
So as the economy regained its footing, the evolution of rates was a foregone conclusion. The Fed would move gradually to avoid upsetting the recovery, but the program of incremental rate hikes was effectively on autopilot, rising inevitably toward a neutral stance.
The pace of normalization has been surprisingly gradual. When the current hiking cycle began, headline unemployment had already fallen within the 5 to 6 percent zone assumed to mark the labor market’s minimum sustainable jobless rate. But instead of raising rates abruptly to cut off job growth before the market overheated, policymakers took a more flexible approach. Gradual normalization allowed the labor market to absorb the hidden slack from millions of discouraged workforce dropouts. Now that interest rates are closing in on their natural equilibrium, the next steps for policymakers will depend on the behavior of growth and inflation.
For the first time in a decade, the economy is operating close to its full potential, making demand-driven overheating possible once again. With the labor market back to full strength and 7 million job openings still unfilled, there is no longer a need for accommodative monetary policy to stimulate job growth. Market forces will efficiently allocate capital through the peak of the business cycle without the Fed intervening to create more favorable conditions for borrowers. In the current environment, interest rates will no longer follow a preset trajectory.
Periods of full employment have never lasted long, so it’s natural to wonder if the Fed is shifting toward a defensive stance against the next downturn. Past business cycles have ended when unsustainable aggregate demand created an inflationary spiral, forcing interest rates higher.
Today, however, there is little evidence of overheating. Inflationary pressure remains modest, edging toward its official 2 percent target. In his remarks last week, Powell characterized the financial system’s vulnerabilities as moderate with no obvious systemic risks. There doesn’t appear to be an asset bubble emerging that could require intervention from the Fed, at least nothing akin to the dotcom bubble that preceded the 2001 recession, or the massive housing bubble whose collapse sparked the 2008 financial crisis.
Ultimately, the Fed anticipates raising short-term rates to only 2.25 to 2.5 percent by the end of the year. This gives policymakers plenty of room to maneuver. The hiking cycle is becoming data-dependent as rates enter the lower bound of their natural equilibrium, which policymakers believe to rest between 2.5 and 3.5 percent. This still gives the Fed room to act if inflationary pressures begin to build.
Next year, policymakers will debate changes to the tactics and strategies that guide monetary policy. Critics have long complained that the official 2 percent inflation target is too low, constraining the bank’s ability to intervene during recessions. Indeed, following the previous recession, even a zero percent rate target was insufficient to restore growth, forcing the Fed to engage in unconventional quantitative easing measures.
Some participants advocate targeting growth instead of inflation. Long-term interest rates are anchored by the economy’s potential for expansion. Adopting a nominal growth target could give the Fed more leverage in a future recession—by pushing short-term borrowing costs well below inflation expectations, rate cuts could stimulate a stronger wave of capital investment and consumer spending.
Ultimately, this academic debate seems unlikely to result in a policy revision. The official 2 percent inflation target anchors market expectations and provides the Fed with hard-won credibility. The 2008 downturn was exceptionally severe; while an unconventional policy response was necessary, the Fed’s actions successfully incubated the longest expansion in modern history. It would be surprising if policymakers decided to stray from the current proven strategy.
As the expansion matures, the Fed will increasingly base its decisions on the evolution of inflation and employment. By taking policy off autopilot and closely watching conditions on the ground, policymakers will be able to make decisions that prolong the peak of the business cycle and maintain full employment for as long as possible.
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