In the graph at the end of this post, the ideal AD line is AD2. Less than that means we don't have full employment. More than that means prices go up too much (too much inflation). And the extra GDP is probably not sustainable.
The Fed would like to set the interest rate (the Federal Funds Rate-see related post How Does the Fed Use Its Monetary Policy Tools to Influence the Economy? (they don't use open market operations to control the federal funds rate)) so that we are at AD2. A higher interest rate reduces AD and a lower rate increases it.
The rate that keeps us at AD2 is the neutral rate. It also gives us the full-employment unemployment rate (the lowest rate of unemployment compatible with price stability, an inflation rate of 2% or less). In addition to uncertainty about what the neutral interest rate is and what the the full-employment unemployment rate is, policy makers are not sure how long it takes for their changes to affect the economy (the lags).
Below are quotes from different policy makers on these issues that highlight the uncertainties. These quotes are all from WSJ articles in the past year.
"Officials want to see evidence that economic activity, hiring and wage growth are slowing, even if inflation subsides somewhat faster than anticipated in their June projections. But just how much more proof is an open question.
Some economists, including Chicago Fed President Austan Goolsbee, have suggested that because wage growth lags behind price growth, a slowdown in inflation could on its own be enough to justify an end to rate increases. Other policy makers, including Dallas Fed President Lorie Logan, have said that because labor markets have been slower to cool than previously anticipated, the Fed will need to continue to raise rates for longer."
See Fed Set to Raise Rates to 22-Year High. Here’s What to Focus On. by Nick Timiraos.
"Uncertainty over the path of inflation later this summer makes it hard to predict the Federal Reserve’s next steps following a likely quarter-percentage point increase in interest rates this week.
Some Fed policy makers and economists are concerned that the easing in inflation will be temporary. They see inflation’s slowdown as long overdue after the fading of pandemic-related shocks that pushed up rents and the prices of transportation and cars. And they worry underlying price pressures could persist, requiring the Fed to lift rates higher and hold them there for longer.
Other economists say that thinking ignores signs of current economic slowing that will gradually subdue price pressures. They also argue inflation will slow enough to push “real” or inflation-adjusted interest rates higher in the coming months. That would provide additional monetary restraint even if this week’s rate increase is the last of the current tightening cycle."
"The first camp of economists is nervous that there is too little slack and too much demand in the economy to be reasonably confident that inflation will return to the Fed’s 2% inflation target in the coming years. They don’t share investors’ recent optimism that inflation can sustainably ease without a broader economic slowdown, though they concede coming data could bolster hopes the Fed can achieve a so-called soft landing, where it contains price pressures without putting the economy in recession.
Many of these economists worry that wage growth is too strong. Without a recession, they see a tight labor market pushing up core inflation next year.
Since an overheated labor market is likely to show up first in wages, many see pay gains as a good proxy of underlying inflation pressure.
Officials are likely to see 3.5% annual wage growth as consistent with inflation between 2% and 2.5%, assuming productivity grows around 1% to 1.5% a year.
Wages and salaries rose 5% in the January-to-March period from a year earlier, according to the Labor Department’s employment-cost index."
"The second camp of economists believe there is ample evidence that the labor market is cooling, in turn taking pressure off inflation.
The amount of time it is taking unemployed workers to find new work has been growing. Increases in hours worked by private-sector employees has slowed along with the number of unfilled jobs. “This is pointing to a labor market that is really slowing in earnest,” said Jonathan Pingle, chief U.S. economist at UBS."
See Why the Fed Isn’t Ready to Declare Victory on Inflation by Nick Timiraos.
"None of this was due to economic slack. The post-pandemic boom continues. The unemployment rate has been remarkably steady in the 3.5% to 3.7% range since the Fed began tightening. That’s below what most economists think of as the “full employment” or “natural” rate. (The Fed’s current estimate is 4%.)" [notice it says most not all economists]
See Team Transitory Had a Point About Inflation by Alan Blinder.
"Powell said because the Fed had lifted rates so quickly last year, there hasn’t been enough time to see the effects of those moves in slowing economic activity and inflation."
See Powell Says Fed’s Inflation Fight Could Take Years by Nick Timiraos and Tom Fairless.
"Richmond Fed President Tom Barkin told reporters last week he didn’t favor a strategy of moving rapidly to an estimated peak rate before pausing rate increases because he isn’t confident the central bank can gauge how much its past rate moves are slowing the economy. “That theory, to me, requires more confidence in understanding” the effectiveness of tighter rate policy “than I have,” he said."
See Fed Minutes Show Most Officials Favored Quarter-Point Rate Rise by Nick Timiraos.
"we face uncertainty about the lagged effects of our tightening so far and about the extent of credit tightening from recent banking stresses"
See Fed Officials Were Divided Over June Rate Pause by Nick Timiraos.
"“Given how uncertainty abounds about where these financial headwinds are going, I think we need to be cautious,” he said. “We should gather further data and be careful about raising rates too aggressively until we see how much work the headwinds are doing for us in getting down inflation.”"
"Philadelphia Fed President Patrick Harker, who also voted to approve both rate rises this year, likewise signaled greater caution in determining further increases during remarks Tuesday evening. Because it can take 18 months for rate rises to influence economic activity, officials would need to closely follow “available data to determine what, if any, additional actions we may need to take,” he said in remarks at the Wharton School at the University of Pennsylvania."
See Fed Official: ‘We Need to Be Cautious’ on Raising Rates After Bank Failures by Nick Timiraos.
"The yield on the three-month Treasury bill, for example, is well above that on the 10-year Treasury note. In the past such yield-curve inversions have almost always augured a recession. Indeed, a yield-curve-based model from the Federal Reserve Bank of New York puts the odds of a recession occurring over the next year at 71%."
"GDP data are also subject to revisions: Of the 29 quarters since 1965 where GDP was initially reported to have declined, 7 are now in the positive column while several initially reported gains are now marked negative. Snaith is less sure about his recession call: “I’m down to a coin flip now.” [Sean Snaith of the University of Central Florida]
Overconfidence among forecasters isn’t a new phenomenon. Don Moore, a professor at the University of California, Berkeley’s Haas School of Business, and Sandy Campbell, a graduate student there, have found that the economists surveyed by the Philadelphia Fed have consistently been too convinced that their forecasts are accurate. It isn’t just economists. “As human beings, we want to be certain,” says Moore. “The truth is we live in a highly uncertain, probabilistic world.”
"The crosscurrents of economic resilience and the lagged effects of past rate increases underscore how, with short-term rates now at a 16-year high, nearly any rate strategy at this point carries more peril than earlier in the rate-increase process.
“It’s easier to make mistakes because it’s harder to figure out what’s happening to the economy in real-time,” said former Fed governor Jeremy Stein. “The risk that you make a monetary policy mistake has gone up.”"
"When mapping out how much further and faster to raise rates, “it calls for a different, somewhat more complicated kind of analysis—surely more complicated than being dependent on the last inflation reading and the last job report,” said former Fed governor Daniel Tarullo.
One challenge for officials is that economic activity has continued to outperform expectations. Low inventories of homes for sale, for example, have boosted sales of new homes and home prices in recent months."
See Fed-Rate Projections Could Rise to Underscore Inflation Anxieties by Nick Timiraos.
"It is now a commonplace, well understood by the FOMC, that the effects of monetary policy on the economy occur with “long and variable lags,” a phrase Milton Friedman coined more than 60 years ago. Both adjectives in the phrase are important, but start with “long.”
"How long? Decades of research prior to the pandemic, spanning many different models, offer numerous answers. But as a rule of thumb, think of the rough “consensus” as suggesting a lag of about a year or so between a monetary policy action and its major effects on real gross domestic product, and perhaps an additional year or so before major effects on inflation."
"The center of gravity of the 10 Fed rate hikes was September 2022. Add a year to see the real effects, and you have September 2023. Adding another year to see the effects on inflation takes you to September 2024, a long way off. But will this tightening follow historically average patterns?
That’s where the “variable” piece comes in. Many monetary policy tightenings and easings depart from the average. Some go faster, some slower. And in this particular business cycle, precipitated by the pandemic and the recovery from it, just about everything has been unusual."
"As a result, markets have gotten so good at anticipating Fed actions that market interest rates typically move before the Fed does."
"a supply bottleneck for computer chips left the industry unable to meet demand for months, creating a huge backlog that is now being worked off. Contrary to historical norms, motor-vehicle sales are actually higher today than they were when the Fed started tightening—suggesting a longer policy lag."
"some unusual factors point to longer lags and some to shorter ones. My personal assessment is that the factors suggesting longer lags look more powerful this time around."
See What to Make of the Fed’s Interest-Rate Pause by Alan Blinder.
"The neutral rate can’t be observed, only inferred by how the economy responds to particular levels of interest rates. If current rates aren’t slowing demand or inflation, then neutral must be higher and monetary policy isn’t tight.
Indeed, on Wednesday, Fed Chair Jerome Powell allowed that one reason the economy and labor market remain resilient despite rates between 5.25% and 5.5% is that neutral has risen, though he added: “We don’t know that.”
Before the 2007-09 recession and financial crisis, economists thought the neutral rate was around 4% to 4.5%. After subtracting 2% inflation, the real neutral rate was 2% to 2.5%. In the subsequent decade, the Fed kept interest rates near zero, yet growth remained sluggish and inflation below 2%. Estimates of neutral began to drop. Fed officials’ median estimate of the longer-run fed-funds rate—their proxy for neutral—fell from 4% in 2013 to 2.5% in 2019, or 0.5% in real terms.
As of Wednesday, the median estimate was still 2.5%. But five of 18 Fed officials put it at 3% or higher, compared with just three officials in June and two last December."
"Between the 2008 financial crisis and the start of the pandemic in 2020, Fed officials and economists had concluded the neutral rate of interest—the level that balances supply and demand when the economy is operating at full strength—had declined sharply. That, together with weak growth following the crisis, ushered in a period of historically low-interest rates.
In recent economic projections, a few officials appear to have raised their expectations for the long-term neutral fed-funds rate. Most officials estimate this rate to be around 2.5% when inflation is 2%. If more officials lift their projections for the neutral rate, that would suggest that interest rates on mortgages, credit cards, and business loans are likely to settle at higher levels even if inflation falls lower."
See Fed Debates When to Stop Raising Rates. What to Watch at Wednesday’s Meeting by Nick Timiraos.