Inflation over the past 12 months has been 6.9% as measured by the CPI. This is the highest headline inflation reading since the early 1980s. Stripping out food and energy yields a core CPI inflation rate of 5.0%, which is the highest reading of that measure since 1991. Over the same time period, unemployment has fallen from 6.7% to 4.2%. Although higher than its value pre-Covid (3.5%), this is among the lowest levels of unemployment the U.S. economy has ever experienced.
So, what should the Fed do about this?
Much depends, of course, on how one expects inflation will evolve over the next 12 months. Professional forecasters currently expect a sharp fall in inflation over the course of 2022 to 2.7% for headline CPI inflation (2.6% for core CPI inflation). I worry that this forecast is overly optimistic. Demand is likely to remain high next year due to high liquid savings of households and sky-high asset prices. Supply disruptions will likely abate some, but it is hard to forecast how fast labor force participation will recover from the Covid shock. Furthermore, some knock-on effects of this year’s inflation in the form of high wage inflation in 2022 is likely to put pressure on costs. For these reasons, I think the most likely outcome for inflation in 2022 is something between 3% and 4%. If all goes well, inflation might be in the 2% to 3% range by late 2023.
What the Fed should do also depends on one’s view about slack in the labor market. As noted above, unemployment is already very low. Abstracting from special Covid factors, unemployment can likely fall somewhat further without causing overheating. But it seems prudent to venture into that territory with some care. Labor force participation, however, is still far below its pre-Covid level. Some of that fall may be permanent (e.g., due to retirement). The rest may take time to resolve itself, and in the meantime is holding back the productive capacity of the economy – something the Fed must recognize as it tries to find a balance between supply and demand in the economy. These considerations suggest to me that the Fed should (at least) be aiming to bring the federal funds rate up to a roughly “neutral” level reasonably quickly.
That raises the question: What is the neutral level of the federal funds rate? Here it is essential to think in real terms, i.e., to consider what real interest rate a given federal funds rate implies. In other words, we need to consider what the neutral real rate (r*) is. Back in the 1990s the consensus view was that r* was something on the order of 2%. Most economists believe it has fallen since then. I am very uncertain about what r* is at the moment. But I think it seems reasonable to suppose it might be close to zero.
Putting this all together, I think the Fed should be aiming to raise the federal funds rate relatively quickly up to about 2.5%. My preference would be to start rate increases at the March 2022 meeting and raise rates by 25bp at each meeting until the federal funds rate reaches 2.5%. As always, the Fed should closely monitor developments during this period. If inflation falls faster than I expect or the unemployment rate starts rising, the Fed should reassess. On the other hand, if inflation in 2022 and 2023 is higher than I expect, the Fed should raise the federal funds rate faster and to higher levels.
The market currently forecasts only a few quarter-point rate increases in 2022. This forecast implies substantially negative short-term real interest rates over the course of 2022. To me, that is too accommodative policy given the current state of inflation and unemployment.