It is tempting to give America’s Federal Reserve great credit for its recent about-face in tackling inflation. Three consecutive rate hikes of 75 bps in the federal funds rate (FFR) represent the sharpest increase in the benchmark policy rate over a four-month time span since early 1982. Yes, but…
The real problem is that the Fed is digging itself out of the deepest hole it has ever been in. The nominal FFR, now effectively at 3.1%, remains five full percentage points below the 3-month average of the headline CPI inflation rate (which averaged 8.4% y/y in July and August and most likely was in the 7.5% to 8% zone in September). Inflation control is all but impossible with a sharply negative “real” federal funds rate of around -5%.
Fed Chair Powell has been explicit in stressing that monetary policy needs to be restrictive to accomplish that task. What defines a restrictive monetary policy? Sticking with my definition of the real federal funds rate based on the headline CPI, the neutral policy rate — basically an average of the real FFR from 1960 to 2021 — is +1.1%. That is fully six percentage points above where the real FFR is today. Restrictive, by definition, must be a number greater than neutrality — for the sake of argument, call it a 2% real FFR. As noted above, with the real FFR at -5%, the Fed is not even close to being restrictive.
Here is where the debate gets tricky: Powell asserted during his September 21 press conference, that Fed policy is now in the “lower end of the restrictive zone.” He made that judgement on the basis of measuring underlying inflation by the so-called “core personal consumption deflator,” which excludes food and energy, and was running at 4.6% y/y through July.
This is disappointing for two reasons: One, the nominal FFR is still well below this measure of core inflation. Two, the Fed’s core fixation is dangerous. That was the case in the early 1970s, when I was part of the Fed’s staff that created the core, and it is the case today. The very premise of the core is to dismiss major price shocks as transitory, as Powell initially did. I am still haunted by the blunders of Arthur Burns in the early 1970s that fell for this ruse by chasing one transitory shock after another. The lesson: A Fed that lives by the core, often dies by the core.
This is a long-winded way of saying that the Powell Fed has much further to go in digging out of the proverbial deep hole. I suspect that the nominal FFR will have to rise into the 5.5% to 6% zone to accomplish that task — implying that the Fed may only be about half done with its inflation-control campaign. That spells recession in the US economy in 2023, which reinforces the downturn already evident in Europe. Export-dependent China, already in the midst of a sharp slowdown, is unlikely to be an oasis in that climate. The blame game always intensifies in a global recession. That doesn’t bode well for an already treacherous US-China conflict.
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