The Federal Open Market Committee opted not to raise its interest rate target at its September 20 meeting. The range for the federal funds rate remains 5.25-5.50 percent. However, several Fed officials hinted another hike could come later in the year. Do we need tighter monetary policy?
The FOMC also released its latest Summary of Economic Projections (SEP) on Wednesday. This contains estimates about the future path of GDP growth, unemployment, and inflation. The last of these is particularly important for ascertaining the stance of monetary policy.
Median estimates for the annual growth rate in the Personal Consumption Expenditures (PCE) index for 2023 were 3.3 percent headline and 3.7 percent core (excluding food and energy prices). The June estimates were 3.2 percent and 3.9 percent, respectively. The slight uptick in headline inflation forecasts is likely due to unexpectedly high energy prices.
Recall that the real (i.e., inflation-adjusted) federal funds rate is equal to the nominal federal funds rate minus expected inflation. Hence, we can use the Fed’s inflation projections to estimate the real federal funds rate. The headline inflation projection implies a real federal funds rate range of 1.95 to 2.20 percent. The core inflation projection implies it is between 1.55 and 1.80 percent.
To gauge the stance of monetary policy, we can compare the real federal funds rate estimates to the natural rate of interest. This is the rate that brings the quantity of capital supplied into alignment with the quantity demanded, promoting optimal resource use throughout the economy. Real output will equal potential output when the market rate of interest equals the natural rate of interest. This is the most that monetary policy can accomplish.
The New York Fed has two estimates for the natural rate of interest. It’s currently between 0.57 and 1.14 percent. Even the lowest real federal funds rate estimated above is significantly higher than the New York Fed’s estimates of the natural rate. That suggests monetary policy is already tight enough.
Liquidity conditions offer supporting evidence. The M2 money supply is falling at an annual rate of 3.69 percent. Broader measures of the money supply, which weight their components by liquidity serviceability, are shrinking between 1.92 and 2.69 percent per year. This is likely a consequence of financial disintermediation. Banks are scaling back their loan-making activities, which contribute to broader money growth, due to the effects of higher interest rates on their balance sheets. Higher rates lower the value of bank assets (e.g., bonds) and increase the costs of maintaining their liabilities (e.g., checking and saving accounts). By simple accounting, this results in lower bank capital (shareholder equity), which then can support only a smaller volume of loans.
Interest rate and liquidity data point to the same conclusion: monetary policy is sufficiently tight. Further tightening could cause a painful economic contraction. This is especially worrying in an election cycle. The Fed is already thoroughly politicized. We must avoid even the appearance of political meddling by central bankers. Instead of cryptic messaging, Fed officials should clearly announce an expected future path for PCEPI growth and stick to it. Central banking should be as obvious and unexciting as possible.