MNI: Fed Will Need Higher Rates Than Expected—Booth Paper

The Federal Reserve will need to raise interest rates beyond current expectations because inflation tends to fall only gradually from high levels – and its decline will require at least a modest recession, according to the flagship paper from the Chicago Booth Monetary Policy Forum.

“Policy will need to tighten further, with rates going higher than their current expected level, and ... the cost of lower inflation to the Fed’s 2% target by 2025 will likely be associated with at least a mild recession,” the paper, written by former New York Fed staffers Stephen Cecchetti and Michael Feroli, in addition to three co-authors.

The Fed earlier this month raised its official interest rate target range by a quarter percentage point to 4.50%-4.75%, reducing the size of the one-meeting rate increase from 2022's torrid pace.

Since then, strong readings on jobs and inflation have raised market expectations for the terminal funds rate up to around 5.3%, some 40 basis points higher this month and above the Fed's December median estimate of 5.1%. The Fed is expected to hike by another 25 basis points in March but a couple of Fed presidents have said a 50-basis-point move should not be ruled out. (See MNI INTERVIEW: Fed May Need To Raise Rates Above 6%)

The annual Booth conference features several FOMC members as discussants and participants.

Strong economic data in recent months, including evidence of a very tight labor market, have raised hopes that the Fed can engineer a soft landing where the fight against inflation is won without a major hit to growth and employment.

Cecchetti and his co-authors argue that such an “immaculate disinflation would be unprecedented."

“There is not post-1950 precedent for a sizable central bank-induced disinflation that does not entail substantial economic sacrifice or recession,” they write. “The Federal Reserve and other central banks will find it difficult to achieve their disinflation goals without a significant sacrifice in economic activity.

The economy created over half a million jobs in January, raising questions about how much impact Fed tightening is having over unusually tight employment conditions.