The Fed is still behind the curve

Media reports suggest that the Federal Reserve has finally decided to tighten monetary policy in order to address high inflation. Indeed, Fed officials insist that policy has been tightening since late last year, as a result of forward guidance pointing to future interest rate increases. In fact, the Fed has not even begun to tighten monetary policy.

It is true that the Fed raised its target interest rate by a quarter of a percentage point at the Federal Open Market Committee (FOMC) meeting last month. It is also true that longer-term rates that are not directly set by the Fed have risen sharply since December, in anticipation of further Fed rate increases. Unfortunately, interest rates are not a reliable indicator of the stance of monetary policy. While rates have been rising, the so-called “equilibrium rate of interest” – which reflects factors such as rising inflation and real economic growth – is rising even more rapidly. The Fed is falling further and further behind the curve.

To better understand the concept of being behind the curve, consider an analogy of a driver steering a bus on a road that bends sharply to the right. If the driver dozes off for a moment, he or she might not turn the wheel until the bus is already entering the curve. Even if the steering wheel is eventually turned to the right, if the adjustment occurs too slowly, the bus might end up in a ditch on the left side of the road.

Monetary policy works in a similar fashion. During periods of rising inflation, the equilibrium interest rate rises as people eagerly borrow money for business investment projects and new homes to take advantage of rising asset prices. If the Fed raises its target rate too slowly, and thus short-term interest rates fall below the (rising) equilibrium interest rate, then monetary policy becomes effectively more expansionary despite modestly higher interest rates. In that case, the slow-reacting Fed is said to be behind the curve.

In order to judge the stance of monetary policy, it is not enough to look at where the Fed sets its interest rate target. We also need to consider the broader goals of monetary policy, particularly inflation expectations. Bond market forecasts of inflation over the next five years have risen significantly since December 2021, indicating that policy is indeed getting more expansionary.

In fairness, some of that increase reflects the anticipated effects of the Russia-Ukraine war, particularly rising energy prices. The Fed generally tries to look past short-run changes in inflation due to supply shocks and focus on longer-run inflation expectations. But even the so-called “5-year, 5-year forward” inflation forecast has been rising. The Ukraine war is not likely to have affected inflation rates between the years 2027 and 2032.

This is not the first time the Fed has made this mistake. During the inflationary late 1960s, interest rates gradually increased. Fed officials were lulled into assuming that monetary policy had been tightened. But inflation expectations were rising even faster than the nominal interest rate. As a result, the real interest rate was actually declining. A declining real cost of credit gives the public more incentive to borrow money to finance spending on new businesses, new homes and new cars, pushing inflation higher.

Throughout the 1970s, the Fed fell ever further behind the curve. By 1981, things were so bad that the Paul Volcker Fed had to push interest rates up to nearly 20 percent in order to break the back of inflation. One side effect was several years of very high unemployment.

Today, things are nowhere near as bad as during 1981. High inflation has been around for barely over a year, and longer-run inflation expectations remain far lower than during the 1970s. Even so, the Fed should not assume that they have done enough to address the inflation problem. They have not even begun to tighten policy.

Scott Sumner is the Ralph G. Hawtrey Chair of Monetary Policy with the Mercatus Center at George Mason University and a professor emeritus at Bentley University.