The End of the Tightening Cycle Is in Sight

Chief Economist Eugenio J. Alemán discusses current economic conditions.

The current Federal Reserve’s (Fed’s) tightening cycle is approaching an end. This has been one of the most forceful as well as the fastest tightening cycle in history. However, because the federal funds rate was well below the neutral federal funds rate, the time it has been above that neutral level has not been that long. Furthermore, it is highly doubtful that the “neutral” federal funds rate has remained at the rate it was before the COVID-19 pandemic recession, which many estimated it to be 2.5%. That is, the current neutral federal funds rate is probably higher than the 2.5% rate estimated before the pandemic recession.

The reason for this is inflation. Before the COVID-19 pandemic, the rate of inflation was, for the most part, below the 2% average targeted by the Fed. However, because inflation has been running above the Fed’s 2% target for two years, it is clear that the neutral rate today is above the 2.5% estimated before the pandemic recession. This means that the federal funds rate has been above the current neutral rate for even less time than if it had stayed at 2.5% during this cycle.

Eugenio J. Alemán, PhD,
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Going forward, however, our expectation is for the neutral federal funds rate to come back to about 2.5% as the Fed continues to target a 2.0% inflation rate for the PCE price index. However, we have heard increased speculation that the Fed may change the inflation target rate “because it will be very difficult to hit 2.0% after what has happened over the last several years,” or something on those lines.

We disagree that this is the case for several reasons. First, you do not change the flag post in the middle of the competition. That is, there is a zero probability that the Fed will change the target rate of inflation… because there are analysts saying that the Fed cannot achieve the current target rate of inflation. The target rate of inflation is a target. That is, the Fed is going to conduct monetary policy to bring the rate of inflation to the target rate, period, independently of what any analyst believes or not whether the target needs to be at 2% or any other number different from 2%. Second, before the COVID-19 pandemic recession, a 3.5% unemployment rate was consistent with a 2% inflation target. However, this may not be true today and monetary policy may have to be adjusted in order to allow for a higher rate of unemployment in order to achieve the target rate of inflation of 2%. Third, if after achieving a 2% inflation over several years, the Fed decides that something different than a 2% for the average inflation rate over the years is better than the current rate target, then they may decide to change it. But this decision will be completely independent from one that says that they cannot attain the 2% target. That is, they will change the target if they believe that a different target is better for the economy than the target they have today, not because they cannot achieve that target.