Has the Fed Monetary Policy been Restrictive?

Not that much!

We assess the policy stance as suggested by Powell in recent press conferences. The following graph shows its recent evolution.

• The monetary policy stance is restrictive when the real interest rate exceeds the neutral real interest rate (i.e., when R-R*>0).

• Based on current various estimates of R*, monetary policy has been accommodative at least until April 2023.

• This implies that most of the recent disinflation is not the byproduct of monetary policy action but the reversal of supply shocks.

• In determining the future stance of monetary policy, higher neutral interest rates might counterbalance increases in the real rates as inflation moderates further.

Background

One of the interesting aspects of recent Powell’s press conferences has been the emphasis on what restrictive (monetary) policy is.  On July 26^th in answering a question by Howard Schneider from Reuters, Powell said:

I would look at it this way though, the real federal funds rate is now in meaningfully positive territory. If you take the nominal federal funds rate, subtract the mainstream estimate of near term inflation expectations, you get a real federal funds rate that is well above most estimates of the longer term neutral rate. So I would say monetary policy is restrictive, more so after today's decision, meaning that it is putting downward pressure on economic activity and inflation. We'll keep monetary policy restrictive until we think it's not appropriate to do so. …

And more recently on November 1st in answering Nancy Marshall-Genzer from Marketplace, Powell reiterated:

“The risk of doing too much versus the risk of doing too little are getting closer to balance, because policy is I think clearly restrictive at 5-1/4 to 5-1/2 percent, that range, if you take off a mainstream estimate of the expected inflation, take one year inflation, you're going to see that you're going to see a real policy rate that is well above mainstream estimates of a neutral policy rate.”

Not surprisingly monetary policy is restrictive to the extent to which it exercises downward pressure on economic activity and inflation; what is more interesting is that Powell emphasized one dimension of how to measure restrictive policy by looking at the difference between the effective real federal funds rate and the longer-term neutral rate. This metric builds upon the logic of the conventional New Keynesian approach, very popular among Central Banks.

Measuring the real neutral rate

So, according to his criteria, when did policy turn restrictive?

I will examine this question by looking at different measures of long-term neutral interest rates and near-term (short-term) inflation expectations.

For the near-term inflation expectations, I will use one-year-ahead inflation expectations from the Michigan survey and the NY Fed Survey of Consumer Expectations.

For the measure of the long-term neutral rate, I consider the implicit one from SEP projection by subtracting the average of the interval of the central tendency (The central tendency excludes the three highest and three lowest projections for each variable in each year) of the long-term nominal Fed Funds rate minus long term PCE inflation (which is always set at 2 percent). Alternatively, I will consider the estimates from Holston, Laubach and Williams, Laubach and Williams, and Matthes and Lubik.

Although the implied real Federal funds rate is computed on a monthly basis, the implied SEP real natural rate and the estimated rates from Holston-Laubach-Williams, Laubach and Williams, and Matthes and Lubik are only available on a quarterly basis.

When we focus on the tightening cycle starting in March 2022, real rates (Fed funds rate minus different measures of expected inflation at the one-year horizon) have turned positive just at the beginning of 2023 for the one based on the Michigan one-year ahead inflation expectations or in April 2023 for the one based on the NY Fed inflation expectation. Their evolution is represented in the following graph.

The next graph describes the stance of monetary policy. I use the different measures of the real fed fund rate, R, and compared it with the alternative measures of the natural rate of interest, R*.

Considering the various combinations of R and R*, monetary policy became restrictive very recently while the disinflation process has occurred during a period in which monetary policy has been in the accommodative territory (even though the degree of monetary policy accommodation has been reduced gradually over time). 

Inflation measured in terms of PCE deflator peaked in in June 2022 at 7.1 percent year on year (yoy) and has declined to 4.5 percent yoy in April 2023 under accommodative monetary policy.

When we consider the core PCE deflator, it peaked in February 2022 at 5.6 percent yoy and declined to 4.7 percent yoy in April 2023.

Conclusions

Has monetary policy been restrictive? And, has monetary policy been effective?

These two questions are naturally linked. According to the logic of the new Keynesian model, widely adopted in many Central Banks, the effectiveness of monetary policy in taming inflation depends on the extent to which is restrictive (R-R*>0).

Interestingly, however, the bulk of the correction of inflation has occurred while monetary policy has been accommodative, as in the immaculate disinflation scenario.

Looking forward the question is for how long the Federal Reserve should keep interest rates high and in a restrictive mode.

There are two forces at play. First, as inflation and short-term inflation expectations decline, short-term real interest rates will increase for a given nominal policy rate (the previous statement implicitly assumes that one-year inflation expectations drift lower as current inflation moderates).

Secondly what matters is also the level of the natural real interest rate, r*. A recent debate is centered around the possibility that the natural interest rates are higher than current model estimates and survey measures. If that is the case, policy might have been more accommodative than this analysis suggests at least based on the logic that builds from the new Keynesian approach to monetary policy stabilization.