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The Fed Needs to Get Real About Interest Rates

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How high will the U.S. Federal Reserve take interest rates? It’s a crucial question, given that the value of trillions of dollars in stocks and bonds worldwide is riding on the outcome.

For markets, the answer suggested by Fed Chair Jerome Powell’s recent statements is not comforting: Probably a lot higher than you think.

Powell didn’t provide a specific forecast at his most recent news conference last week. But he did offer some clues. First, he said the Fed is heading “expeditiously” toward a neutral level of interest rates, which means 50-basis-point increases at each of the next few meetings. Second, he suggested that neutral would likely mean 2% to 3% — assuming inflation was at the Fed’s 2% target. In inflation-adjusted terms, that’s a short-term rate of 0% to 1%.

The connection between the neutral rate and inflation deserves much more attention than it received. It means that if underlying inflation remains high, reaching neutral will require the Fed to take rates much higher than 2% to 3%. Discerning the underlying inflation trend won’t be easy, given sharp shifts in demand — first toward goods and now back toward services — and persistent supply-chain disruptions exacerbated by the war in Ukraine and Covid-related shutdowns in China.

Judging from the labor market, underlying inflation is running well above the Fed’s 2% target. Average hourly earnings are up 5.5% from a year earlier — which, assuming productivity growth of 1.5% to 2%, implies inflation of 3.5% to 4%. This, in turn, suggests a neutral federal funds rate of about 4% — higher than what futures markets currently expect.

Even 4%, though, could easily be an underestimate. For one, the extraordinary tightness of the labor market might push wage inflation still higher. Also, the Fed is still providing stimulus through its vast holdings of Treasury and mortgage securities, which will take three to four years to wind down. As long as the Fed is still holding such assets, the neutral short-term rate will be higher than it otherwise would be.

What’s more, the Fed might need to go significantly beyond neutral to get inflation under control. Powell has so far refused to comment on the possibility, arguing that the central bank must first reach neutral before deciding whether to press on.

This coyness is a mistake. It reinforces the jarring disconnect between Fed officials’ commitment to curb inflation and their unwillingness to explain what that commitment will entail. It’s hard to imagine that the Fed can address persistently above-target inflation without taking interest rates high enough to significantly loosen an extremely tight labor market. Yet in their March projections, officials still forecast inflation falling to within a whisker of their target even as the unemployment rate remained below the level that they assessed as consistent with stable inflation.

If monetary policy operates through financial conditions, as Powell and I agree it does, why obscure what’s necessary to keep inflation in check? If the central bank’s messaging leads market participants to underestimate future tightening, that will leave financial conditions looser now, requiring the Fed to do more of the work through short-term rates. Worse, the Fed’s sugarcoating could undermine its credibility, and hence its ability to do its job.

The Fed needs to be clearer about the means required to achieve its goals. Brutal honesty could spare everyone a lot of trouble in the end.

More From Other Writers at Bloomberg Opinion:

Fed’s Kashkari Reveals an Uncomfortable Truth: Lisa Abramowicz

Powell’s Job Market Theory Is Proving Faulty: Jonathan Levin

Central Bankers Are Handcuffed by Old Narratives: Clive Crook

This column does not necessarily reflect the opinion of the editorial board or Bloomberg LP and its owners.

Bill Dudley is a Bloomberg Opinion columnist and senior adviser to Bloomberg Economics. A senior research scholar at Princeton University, he served as president of the Federal Reserve Bank of New York and as chairman of the Federal Open Market Committee.

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