Where does the Fed stand in meeting its dual objectives?
At their recent meeting, the Fed raised rates by an additional 0.25%, adding to what has been the most aggressive rate hiking cycle in decades. That quarter-point hike was the smallest since last March, following six consecutive increases of 50–75 basis points. While it represented a slowdown in the pace of tightening, the Fed reiterated that it’s not yet ready to pause.
With inflation trending lower and parts of the economy showing signs of weakness, why is the Fed maintaining a hawkish stance? A look at the Fed’s dual mandate of low inflation and full employment helps to tell the story. The chart above illustrates the Fed’s targets for inflation (2%) and unemployment (4%) — the levels they believe are consistent with stable prices and full employment. By comparison, current data for 2022 (top-left quadrant) shows the Fed’s preferred inflation measure well above the Fed’s target, while the unemployment rate at 3.5% remains tighter than the Fed’s estimate of full employment. Both argue for a restrictive policy backdrop today.
Given the lagged effects of monetary policy, it’s impossible for policymakers to know precisely how much needs to be done. The Fed’s dot plot provides forecasts for 2023 and 2024 (top-right quadrant), confirming their belief that unemployment needs to rise above the 4% threshold to achieve both goals. Over the course of this year, the Fed expects its tightening measures to lift the unemployment rate by about 1 percentage point to 4.5%. The risk is that the full force of prior rate hikes has not yet been felt. Even if the Fed did nothing further, conditions would tighten further in the coming year. The Fed must decide how much more to do without knowing what the full impact will be of what has already been done.
Can the Fed get it right this time? It’s possible, but it won’t be an easy task.
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