MNI: Wary Fed Will Test Neutral Rate From Below -- Ex-Staffers

Federal Reserve officials will likely turn cautious as interest rates approach a level they consider neutral, potentially slowing the pace of rate hikes because they fear shocking the economy into recession if financial conditions tighten more quickly than anticipated, former central bank staffers told MNI.

Moreover, ex-staff said the Fed will target a neutral policy rate using a lower trend measure despite recent energy and commodity price spikes, presuming underlying inflation pressures are still under control because much of the recent inflation is driven by short-term supply shocks.

"Neutral should be defined in inflation adjusted terms, but the adjustment should be long-run expected inflation, which has not really moved yet," said Joseph Gagnon, a former Fed board economist now at the Peterson Institute.

While the Fed plans to get to the very bottom of that long-run neutral range in coming months and says it may move to a "restrictive" stance, policymakers have downplayed the need to raise the short-rate above inflation, instead shifting the focus to focus on broader financial conditions and arguing that longer-run rates are already higher.

“Their current trajectory is still maybe barely getting us to neutral if that," said Ken Kuttner, a former assistant vice president at the New York Fed. “Their projected trajectory is still really at the low end just to get to neutral and then if you think the economy is overheating to the point where you need to get contractionary, then there is still a ways to go."

Minneapolis Fed Research Director Mark Wright told MNI last week the Fed might consider slowing the pace of rate increases as rates approach a neutral level.

"The way they'll implement their strategy is to move in steps, and use the observed responses in inflation and unemployment to gauge whether or not they've reached 'neutral,'" said former Richmond Fed staffer Peter Ireland.

'RESTRICTIVE'

FOMC members estimate the long-run neutral borrowing rate is somewhere around 2.4%, when growth is close to potential, inflation is around 2% and employment is near sustainable maximum potential.

Ireland said talk about the neutral rate is mainly a reflection of the central bank's underlying dilemma: "How much of the increase in measured inflation is coming from the supply side versus how much is due to excessive monetary accommodation?"

CPI inflation has jumped to 8.3% in the year to April and the PCE measure has hit 6.3%, and standard guidelines suggest raising the policy rate more than one-for-one to inflation.

“History tells us is if you want to reduce inflation, you have to have the policy rate above the inflation rate," said Michael Bordo, a former Fed and Bank of England researcher, who sees the need for a more aggressive path for the short-rate. “This concept of a neutral rate is kind of misleading, because if you're feeling something that isn't there, then there always assumptions that are going into that.”

FILTERING NOISE

These 'Taylor rule' guidelines recommend raising rates relative to inflation that is not caused by temporary factors. The Dallas Fed's trimmed mean measure is at 3.8% over the last year. Evan Koenig, a former principle policy adviser at the Dallas Fed, told MNI the key measure of trend inflation is likely to average about 4% between now and the first quarter of 2023.

"For the Taylor rule and similar policy guides, it makes sense that you want an inflation gauge that is relatively uncontaminated by 'noise' but which includes inflation’s trend and cyclical components. Trimmed-mean inflation fits the bill very nicely," Koenig said, suggesting a 4.5% neutral policy stance.

While some ex-staff suggested the tightening of financial conditions in recent weeks could reflect a lower neutral rate for the economy, there is broad agreement that a restrictive policy is still needed, with a terminal fed funds rate of at least 3.25%.

Guidance from Fed Chair Jerome Powell has pointed to 50 basis point increases in June and July. Cleveland Fed President Loretta Mester Thursday said "it could be that the relatively swift tightening in financial conditions means that monetary policy will transmit throughout the economy faster than in past cycles and that demand will moderate more quickly."