MNI POLICY: Fed Policy Looks Tight, Bolstering Case For Cuts

Federal Reserve officials judge their policy tight enough to pull down inflation in spite of easy financial conditions and buoyant growth, reinforcing their bias to cut rates as soon as more favorable inflation reports are in hand.

The S&P 500 hit a record high last week and finished 25% above year-earlier levels, and the Atlanta Fed's GDPNow measure is tracking second quarter growth at 3.0%, well above the 2.1% penciled in for the year by the median FOMC official.

Yet Fed officials remain confident that policy is restrictive, citing the decline in their preferred PCE inflation measure to an estimated 2.6% in May, as well as the cooling labor market, a more cautious consumer, and macro models that show high short-run real interest rates. The FOMC held its fed funds rate target at 5.25%-5.5% this month and most officials projected one or two cuts by year-end.

"If you talk to somebody in commercial real estate, they'll tell you it's restrictive. You talk to someone in residential real estate, they’ll tell you it's restrictive. Talk to someone in banking, they'll tell you it's restrictive. Even in manufacturing, you clearly hear it's restrictive. And so it's my strong sense that we are at a restrictive level," Richmond Fed President Tom Barkin said at an MNI Webcast last week.

SPECIAL FACTORS

Barkin pointed to the easing of pressures in labor markets and slowing of consumer spending as evidence that policy is tight. Jobless claims and the unemployment rate have been trending higher, and retail sales results were weaker than expected for a second straight month in May.

Whether policy is sufficiently restrictive is up for debate, officials acknowledge, but the Fed is prepared to wait and see because they consider that pandemic-related special factors are still at work. (See MNI INTERVIEW: Richmond Fed's R-star Estimate Rises To 2.3%)

Excess savings after the pandemic likely dulled the impact of high inflation and interest rates last year. Meanwhile, potential growth appears to be higher due to a boost in labor supply from immigration as well as improved productivity. That means the U.S. economy can grow faster without generating additional inflation.

Over time, restrictive policy should become more apparent as factors supporting demand fade.

MODELS

Estimates of the longer-run fed funds rate by the FOMC are gradually drifting higher, but Fed Chair Jerome Powell and others have emphasized the high degree of uncertainty surrounding the rate, which represents the appropriate neutral policy setting for an economy that isn't experiencing any special factors. (See MNI POLICY: Lively Debate At Fed Over Possible R-Star Rise)

Policy is made in the short to medium run, when the economy is being hit by many shocks, and a short-run r-star consistent with FOMC forecasts for the next two to three years could look very different.

One such estimate, from the New York Fed's dynamic stochastic general equilibrium (DSGE) model, puts the real short-run r-star at 2.5% this year, much higher than its longer-run counterpart. Easy financial conditions translate to higher short-run rates. In spite of that, policy is restrictive.

"We're asking: Is our policy stance about right? And I think we think, yes, it's about right," Powell said in his June press conference. "We're prepared to adjust that as appropriate, but we think we're getting the things that we would want to get, broadly speaking. And that's why we've been at this policy right now for almost a year."