What’s the likely impact of rising rates on both sides of the Fed’s dual mandate—employment and inflation?
When the Fed tightens monetary policy, it raises the federal funds rate—that is, the overnight interest rate at which banks lend to one another. Of course, the federal funds rate doesn’t have large economic effects directly; few businesses and households borrow or lend at the federal funds rate. However, there are several channels through which changes in monetary policy can affect the economy, including through effects on longer-term interest rates, stock prices, and the foreign exchange value of the dollar.
Indeed, as the Fed has tightened policy this year, longer-term interest rates have moved significantly higher, stock prices have declined sharply, and the dollar has increased in value. These changes in financial conditions do have effects on the economy: higher mortgage interest rates have slowed housing activity, lower stock prices are weighing on consumer spending by reducing household wealth, and the strong dollar is damping foreign demand for U.S. exports by raising their cost in foreign currency. As a consequence, employment growth has been slowing of late, and it is likely to slow further as the Fed continues to tighten monetary policy.
Ultimately, slower growth should ease pressures in output and labor markets and help to bring inflation back toward the Fed’s 2 % target. In addition, other factors that have been boosting inflation this year, including COVID-related disruptions and the war in Ukraine, should gradually ease, helping to bring inflation down.
Given the lag between when the Fed sets policy and the impact on the economy, how can the Fed know when it’s the right moment to make a change?
“Since the peak effects of a change in monetary policy aren’t felt for a year or more, policymakers need to base their assessment of the appropriate stance of policy on forecasts for the economy a year or so ahead.”
Unfortunately, the Fed can’t know for sure. Lags make monetary policy difficult because policymakers don’t know how the economy is going to evolve. Indeed, since the peak effects of a change in monetary policy aren’t felt for a year or more, policymakers need to base their assessment of the appropriate stance of policy on forecasts for the economy a year or so ahead. But such forecasts are always subject to considerable uncertainty, and that uncertainty is particularly large today, given the possible effects of COVID as well as elevated geopolitical risks. Moreover, the Fed likely isn’t very confident in its forecasting ability at the moment, since it repeatedly failed to anticipate the high inflation seen over the past 18 months.
All that being said, the Fed has no choice but to set policy in a forward-looking manner. For example, if the Fed instead raises interest rates rapidly until the economy slows by enough to get inflation to fall, the lags in the effects of policy mean that the economy is likely to subsequently slow too much, as the full effects of the policy tightening on economic activity are felt. The result could be a significant recession and inflation falling well below target.
Do you see signs in this meeting of what steps the Fed might take in future meetings?
The Fed had been clear in recent months that it expected to raise rates rapidly for a while given persistent high inflation. And at its latest meeting, the Fed again indicated that ongoing increases in the federal funds rate would likely be appropriate to return inflation to its 2% target. However, with the federal funds rate nearly 4 percentage points higher than it was in March, policymakers also acknowledged that their policy decisions would need to take account of the substantial “cumulative tightening in monetary policy” and the “lags with which monetary policy affects economic activity and inflation.” These comments suggest that the pace of policy tightening is likely to slow fairly soon, with Chair Powell suggesting that the time to slow the pace of tightening might come at the December or January policy meetings. Beyond that, it will be appropriate at some stage for the Fed to cease tightening, but the timing of that step is highly uncertain, and will depend on the incoming data on the economy and the implications of those data for the economic outlook.