Policy Has Tightened a Lot.
How Tight Is It?

On May 6, 2022, I first published an essay explaining why I focus on long-term real rates to evaluate the overall stance of monetary policy, which includes effects from both the setting of the federal funds rate and changes to the Federal Reserve’s balance sheet. Please see that essay for a discussion of why long-term real rates drive economic activity rather than short rates or nominal rates.

On June 17, 2022, and September 26, 2023, I published updates to reflect actions by the Federal Open Market Committee (FOMC) to tighten policy in order to bring inflation back to our target. This essay is an update to those earlier commentaries to assess where we are in our inflation fight and highlight some important questions policymakers face.

Since my last update in September, two significant economic developments have occurred simultaneously: Inflation has fallen rapidly—more rapidly than most forecasters expected—and economic growth has proven remarkably resilient, even stepping up in the latter half of 2023.

The FOMC targets 12-month headline inflation of 2 percent. The fact that core inflation is making rapid progress returning to our target—as demonstrated by six-month core inflation coming in lower than 12-month, three-month coming in lower than six-month, and both now at or below target—suggests that we are making significant progress in our inflation fight (see Figure 1).

At the same time that inflation has made rapid progress toward our goal, real GDP growth has continued to show remarkable strength, as shown in Figure 2.

The labor market, the other half of our dual mandate, has also remained strong with the unemployment rate remaining at a historically low 3.7 percent.

How do we reconcile such strong real economic activity with falling inflation? Typically, if tight monetary policy were the primary driver of falling inflation, we would have seen falling inflation coupled with weak economic growth and a weakening labor market, perhaps including a material increase in unemployment. But that is not what we have experienced in recent quarters.

Instead of monetary policy doing the heavy lifting to bring inflation down, it appears that supply-side increases are boosting output and bringing supply and demand into balance, thus reducing inflation. I previously described that high inflation was being driven by “surge pricing” dynamics, where demand was hitting the vertical part of the supply curve. By most measures, supply chains that had been disrupted during the pandemic have healed and there has been a strong boost to labor supply, increasing the economy’s potential output and bringing inflation down.

If supply-side factors appear to be contributing meaningfully to disinflation, what role has monetary policy played and how is it affecting the economy now? Monetary policy has played an enormously important role in keeping long-run inflation expectations anchored. It is hard to overstate how important that is for ultimately achieving the soft landing we are all aiming for. But to assess what impact policy is having on inflation going forward, we must first try to determine how tight monetary policy actually is.

Recent public commentary suggests that the real federal funds rate has tightened dramatically over the past several months because inflation has fallen rapidly while the nominal federal funds rate has remained unchanged. While I understand the math of this argument, I believe it overstates changes in the stance of monetary policy.

In prior essays I wrote that the single best proxy for the overall stance of monetary policy is the long-term real rate, specifically the 10-year Treasury inflation-protected securities (TIPS) yield. Focusing on a long-term rate incorporates the expected path of both the federal funds rate and balance sheet, not just the current level of the federal funds rate. Moreover, it adjusts the expected path of policy by expected future inflation—the relevant comparison—rather than by recently realized inflation.

While 12-month inflation has fallen 285 basis points (bps) over the past year—implying that the real federal funds rate has climbed 360 bps—Figure 3 shows that policy as indicated by 10-year TIPS has only increased about 60 bps on net. Now, one reason the 10-year TIPS yield has not moved up much while inflation has fallen is that the expected path of nominal rates has also fallen. If markets instead expected no change in the federal funds rate this year, then, all else equal, real rates would have moved up further.

The concept of a neutral stance of monetary policy is critical to assessing where policy is now and what pressure it is having on the economy. While we cannot directly observe neutral, economists have models to estimate it, which are imperfect even under normal economic circumstances. Our various workhorse models for the economy have struggled to explain and forecast the pandemic and post-pandemic periods given the extraordinary changes and disruptions the economy has experienced. So I also look to measures of economic activity for signals to try to evaluate the stance of policy.

To assess if monetary policy is tight, I start by looking at what are traditionally the more interest-rate-sensitive sectors of the economy for signs of weakness. Start with housing: While home sales are down relative to the pre-pandemic period, overall residential investment was flat in real terms in 2023. Construction employment has not fallen during our tightening cycle and instead continues to climb to all-time highs. While home price growth has slowed, prices have not fallen and are quite high by historical measures, contributing to record household wealth. Even the stock prices of homebuilders are near all-time highs.

Private nonresidential investment was up 4.1 percent in 2023, and consumption of durable goods was up 6.1 percent. And with the backdrop of low unemployment noted above, consumers continue to surprise with robust spending.

These data lead me to question how much downward pressure monetary policy is currently placing on demand.

But the data are not unambiguously positive, and there are some signs of economic weakness that I take seriously, such as auto loan and credit card delinquencies increasing from very low levels and continued weakness in the office sector of commercial real estate.

This constellation of data suggests to me that the current stance of monetary policy, which, again, includes the current level and expected paths of the federal funds rate and balance sheet, may not be as tight as we would have assumed given the low neutral rate environment that existed before the pandemic. It is possible, at least during the post-pandemic recovery period, that the policy stance that represents neutral has increased. The implication of this is that, I believe, it gives the FOMC time to assess upcoming economic data before starting to lower the federal funds rate, with less risk that too-tight policy is going to derail the economic recovery.