MNI INTERVIEW: Fed Economist-Low For Long Rate Can Tame CPI

The Federal Reserve can meet its inflation target by keeping interest rates at a lower peak for longer, rather than by making more aggressive hikes, Chicago Fed researcher Leonardo Melosi told MNI.

Markets already anticipate that the Fed will opt for a lower-for-longer approach, senior economist and economic adviser Melosi said in an interview, pointing to investors’ expectations at the end of last year for the policy rate to peak in 2023 at a level 75 basis points lower than that suggested by an economic model weighted to past Fed tightening cycles.

The historical model and financial markets both see "inertia" as interest rates rise to fight inflation, but also when borrowing costs are on the way down again, he said. Less than half the modeled Fed rate hikes are predicted to unwind by early 2025.

Central banks have been criticized for leaving interest rates low for too long while inflation surged and for hiking into potential recessions. Fed officials say the bigger danger is for rapid price gains to become embedded in the economy, requiring an even more painful tightening later.

TEMPTING OR ENTERTAINING

“It’s perhaps tempting or entertaining to say the Fed is behind the curve in 2021, or in 2022 it’s too high, it’s too aggressive,” Melosi said. “You need to take a longer perspective, and look at how the central bank responded to the big increase in inflation over the entire tightening cycle.”

The more dovish market path for rates still shows inflation coming to about 2% in 2025, according to a paper Melosi co-authored with Filippo Ferroni and Jonas Fisher.

“What basically the model is telling you is the central bank has enough reputation so that the market knows that even though the central bank doesn’t respond aggressively to inflation, still it will deliver later on,” Melosi said.

In the end, the gap between the two ways of looking at Fed hikes may end up narrowing. Fed Chair Jerome Powell earlier this week jolted markets by saying he's willing to look at ramping up the path of rate hikes again. (See: MNI INTERVIEW: Fed Should Hike 50BPS If Data Stay Strong-Kohn)

THE CUMULATIVE RESPONSE

There are benefits to a smoother response to an inflation shock, such as avoiding financial-market disruptions, Melosi wrote in the paper, "How Tight Is U.S. Monetary Policy?"

Asked in the interview for the answer to that question, Melosi said: “We need to wait and see the entire tightening cycle, and to look at the cumulative response of the interest rate to the increasing inflation.”

The finding of a somewhat smooth interest-rate path amid the fastest inflation in decades was a surprise to the researchers. “We expected that the model would give us a completely outlandish” path, he said.