By William H. Buiter

So far this century, the US Federal Reserve has been relentlessly gradual in raising the federal funds rate. Since its last 50 basis point rate hike in May 2000, the Fed has only increased its policy target (now its target range) 25 basis points at a time. It wasn’t always like that. After switching to rate targeting in late 1982, the Fed raised the fed funds rate by more than 1% on one occasion, 75 basis points on three other occasions, and 50 basis points on nine other occasions. .

On the other hand, on the eve of the financial crisis of 2007-2009, from June 2003 to June 2006, the Fed raised its key rate from 1% to 5.25% through 17 scheduled hikes of 25 basis points each. . And in the last hike cycle, which began in December 2015, the upper limit of the Fed’s target range increased nine times by 25 basis points each, taking it from 0.25% to a peak of 2, 5% in December 2018.

But the Fed was not so gradual in its descent. Beginning in August 2019, the Fed returned to an effective lower bound of 0.25% with three 25 basis point rate cuts, followed by a 50 basis point rate cut at an unscheduled meeting on March 3, 2020, and an additional 100 basis points. cut in a second unscheduled meeting on March 15, 2020.
Now that the Fed is once again considering tighter monetary policy, should it embrace the same gradualism it has for the past two decades?

The latest inflation figures suggest that may not be the case. In January 2022, the consumer price index was up 7.5% year on year, with underlying inflation (excluding food and energy) reaching 6%. Personal consumption expenditure in December 2021 was 5.8% higher than in December 2020, with underlying inflation standing at 4.9%. Of the nine measures of underlying inflation tracked by the Federal Reserve Bank of Atlanta, annual increases in January 2022 ranged from 3.1% to 6%. The average hourly wage had increased by 5.7%.

So where should the policy rate be and how quickly should the Fed move to get there? A good starting point is the neutral policy rate, where the fed funds rate would be with inflation at its target level and full employment. A reasonable estimate of the neutral rate is 2.5%, which is also in line with the Fed’s estimate of the longer-term federal funds rate. The policy rate must be above (or below) the neutral rate if inflation is above (or below) the target and if the unemployment rate is below (or above) the “natural” or equilibrium unemployment rate .

Even taking the most conservative estimate, inflation is currently 1.1% above target, and it is no longer tenable to say that it is “transitional” – the result of base, temporary adverse supply shocks (including supply chain disruptions) and short-term spikes in energy and other commodity prices. The January 2022 unemployment rate (4%) is slightly above its pre-COVID low (3.5%), and non-farm employment is 1.9% below its pre-pandemic level in February 2020.

However, empirical data on unemployment (high vacancies and high quit rates) support the view that structural mismatch and frictional unemployment have increased and the economy is currently at full employment or slightly above. After all, real GDP (adjusted for inflation) is back to its pre-COVID trend.

This is consistent with the economy operating at or above capacity, as consideration must be given to the likely permanent negative effects of Covid-19, cybercrime, climate change, demographics and de-globalization on potential output. The continuation of the Fed’s dual mandate – stable prices and maximum employment – ​​therefore calls for a target federal funds rate well above 2.5%.

Assume, conservatively, that the lower limit of the target range should not be less than 3.5%. A 3.5% federal funds rate does not pose a threat to financial stability if there is adequate funding liquidity for systemically important financial institutions and adequate market liquidity for systemically important financial instruments . The United States and the global economy have lived comfortably with a significantly higher federal funds rate for many years.

Some commentators will warn that a rapid and unexpected increase in the policy rate could threaten financial stability in the United States and abroad, particularly in emerging markets, where public and private agents have taken on large debts, often for short periods. duration, denominated in dollars. But financial crises are not caused by high interest rates or rapidly rising interest rates. They are caused by a lack of funding liquidity and market liquidity.

So I have only limited concerns about the domestic impact of a rapid sequence of rate hikes, say a 150 basis point hike in March followed by two consecutive 100 basis point hikes at the next regular meetings of the Federal Open Market Committee. When needed, the Fed now knows how to provide funding liquidity as lender of last resort and market liquidity as market maker of last resort.

The negative international repercussions of a rapid rise in rates are more worrying. The Fed’s bilateral currency swaps do not cover many financially vulnerable emerging markets and developing countries, and the International Monetary Fund has limited resources to operate as a global lender of last resort. Given these constraints, it would make sense to pursue a slightly slower tightening cycle of, say, a 100bps hike followed by five successive 50bps hikes.

Be that as it may, when it comes to the American economy, neither prudence nor the precautionary principle calls for progressiveness. The credibility of the Fed’s commitment to price stability is at stake. Unless the Fed raises interest rates quickly to limit aggregate demand, inflation will continue to overshoot its target. Long-term inflation expectations may not yet be rooted out, but this is a real and growing risk.

Although the market-based five-year and five-year forward inflation rate was 2.07% on February 15, 2022, inflation expectations in the short to medium term are already well above target. from the Fed. The Federal Reserve Bank of New York’s January 2022 survey of consumer expectations puts median one- and three-year inflation expectations at 5.8% and 3.5%, respectively. Similarly, the University of Michigan Consumer Survey in January 2022 pegged one-year inflation expectations at 4.9% and five-year expectations at 3.1%.

To preserve its credibility, the Fed must take decisive action. Another endless streak of 25 basis point hikes won’t be enough.

The author is Assistant Professor of International and Public Affairs at Columbia University

Copyright: Project Syndicate, 2022
http://www.project-syndicate.org