Recent economic developments suggest that the Federal Reserve may be using inflationary pressures to elevate its policy interest rate to a new, higher level. Historically, the Fed has been slow to react to rising inflation, but the current inflation cycle appears to have altered that pattern. The Fed allowed inflation to exceed 2% for 12 months before beginning to raise rates, an unprecedented approach.
The Drivers of Inflation
Since March 2021, the U.S. economy has seen Personal Consumption Expenditures (PCE) inflation rise to 2.7%, with core PCE inflation hitting 2.2%, surpassing the Fed's 2% target. Despite this, the Fed did not start raising rates until March 2022, when PCE inflation had already surged to 7.0%. This delay allowed inflation to peak and resulted in a rapid increase in interest rates.
When comparing data from September 2024 to September 2019, the Fed’s forecast for long-term economic potential has been slightly lowered, while the median policy rate has been raised. In essence, the Fed is using higher inflation expectations to justify maintaining a higher rate level, thereby mitigating the risk of hitting the effective lower bound on interest rates.
Changes in the Neutral Rate
The Federal Reserve’s policy rate is typically calculated using a formula: Policy Rate = Neutral Rate + Inflation Rate. The key issue lies in the fluctuation of the neutral rate. Estimates suggest that the neutral rate, post-pandemic, is around 60 basis points higher than its low following the 2008 financial crisis. This implies that the Fed may be allowing inflation to overshoot slightly to maintain a higher policy rate.
The Fed’s Future Policy Direction
Currently, the Federal Reserve appears to be leaning toward maintaining a slightly higher-than-2% inflation target, while prioritizing the stability of the labor market. Whether this approach will hold over the long term depends on the Fed's ability to keep inflation slightly above 2% while reducing unemployment and boosting potential output growth.
For financial markets, this long-term policy uncertainty could influence investor decisions. Understanding this shift in the Fed’s policy direction is crucial for forex and financial market participants.
