By Warren B. Hrung
This post presents a simple schematic (no equations!) to help understand how the Federal Reserve may approach its interest rate policy decisions for the remainder of 2024. The Fed is typically characterized as having a dual mandate of maximum employment and stable prices. The conduct of monetary policy is geared towards these goals and various frameworks have been developed to understand how the Fed sets monetary policy via interest rates. For example, one of the frameworks, the famous Taylor Rule, links the policy rate to deviations of inflation from its target and the difference between real GDP and potential GDP. Some other frameworks are covered here.
In January 2012, Federal Reserve policymakers set 2 percent as the long-run target for inflation. There is no current numerical target for employment or the unemployment rate. In a recent speech, Federal Reserve Governor Lisa Cook described the Fed’s approach and referenced its Statement on Longer-Run Goals and Monetary Policy Strategy. This statement notes the “potentially different time horizons” that are expected to be needed for “employment shortfalls and inflation deviations” to close as important considerations when the employment and inflation objectives are deemed to not be complementary (for example, due to an adverse supply shock that initially raises both inflation and unemployment).
A possible target for the maximum employment goal would be the natural rate of unemployment, typically denoted as u*. This is the rate of unemployment that is consistent with a steady inflation rate. Unfortunately, this rate is unobserved and can only be estimated. Furthermore, it can change over time. In the framework below, we will use u*, as estimated by the Fed, as the target for the labor market, all the while acknowledging that other aspects (such as labor force participation) are considered in determining when the maximum employment goal is being met.
Another aspect of monetary policy relates to decisions regarding the size and composition of the Fed’s balance sheet. The Fed’s asset purchase programs have mostly been intended to lower longer-term interest rates by reducing the supply of longer-term assets held by the public and have been employed when the federal funds rate is near zero. As such, the asset purchase programs can be thought of as another way to lower interest rates and therefore can be subsumed in the framework below. The Annual Reports on Open Market Operations provide more details on Fed balance sheet growth and reduction programs.
Cook notes that the situation in 2022 and going into 2023, where unemployment was at historic lows and inflation running at multi-decade highs, implied a “forceful tightening of monetary policy.” This suggests a framework that can be distilled into the following two-by-two matrix (Figure 1) in which the rows denote cases where the unemployment rate is below or above u* (with a dashed line to denote the uncertainty of the true value of u*) and the columns represent cases where inflation is below or above the 2 percent target.
The innovation here is not in the direction of monetary policy, but in its degrees of aggressiveness. This simplification obviously won’t capture all the nuances in the Fed’s decision-making process, but hopefully it will help observers better understand the Fed’s approach. And note that the designation of “good” and “bad” categories for u* and inflation are only suggestive of how to consider the current situation and may not necessarily hold for every case. For example, if inflation were to fall close to zero, there could be concerns about deflation, so inflation below target in this case would not be considered “good.”
In the first quadrant, where the unemployment rate is below u* and inflation is below target but trending higher, the Fed would be cautious in lowering rates to bring inflation back to target. This is because looser monetary policy would also risk running the economy too hot, driving the unemployment rate even further below u* and risking an eventual burst of inflation above target.
In the second quadrant, where unemployed is below u* and inflation persistently above target, the Fed has more room to aggressively tighten policy to reduce aggregate demand and bring inflation back to target without triggering a recession and a sharp weakening of the labor market. And if interest rates have already risen substantially and the long and variable lags associated with changes in interest rates have not yet fully been realized in terms of inflation reaching its target, reflective of the current situation, a strong labor market means that the Fed can afford to wait and hold rates higher for longer than otherwise.
In the third quadrant, where both the unemployment rate and inflation are above their respective targets, the Fed will be more cautious in its efforts to increase rates to bring inflation to target. Higher rates risk further exacerbating a difficult labor market situation and increasing unemployment.
And finally, in the fourth quadrant, with a situation where the unemployment rate is above u* but inflation is below target, the Fed can be more aggressive in lowering rates to stimulate aggregate demand with less concern about an increase in inflation. And if the full effect of any interest rate decreases has yet to be fully realized, the Fed may hold rates lower for longer to get inflation back to target.
This two-dimensional representation could be expanded to take into account inflation expectations, which is another key consideration for the Fed. If inflation expectations become unmoored to the upside, the Fed would have to be more aggressive in combatting inflation in all four cases above. As a result, a three-dimensional representation adding inflation expectations (anchored versus unanchored) would complicate the framework without providing much additional insight into the Fed’s decision-making process. Forward guidance can be utilized by the Fed to anchor inflation expectations and this tool is not explicitly considered in the matrix above.
Looking ahead, even though the Fed has already sharply raised interest rates since early 2022, inflation is currently still above target and the risk that inflation expectations become unmoored to the upside also remains. Plus, the unemployment rate is still low at around 4 percent and presumably below u*. Therefore, the paradigm above (second quadrant) suggests the very real possibility of the Fed holding rates at current levels well into 2024 even without presidential politics being taken into account.
