The Fed’s Latest Problem: A Strong Economy

The Fed’s Latest Problem: A Strong Economy
The Fed’s Latest Problem: A Strong Economy


Improving productivity and better-than-expected growth make it risky to cut interest rates too much.

The economy is looking up, and that’s a challenge for the Federal Reserve. The pandemic shock prompted excessive monetary and fiscal responses, generating inflation. The Fed responded with aggressive rate hikes that reduced inflation within reach of its 2% longer-run target. Now that the economy is growing and productivity is improving, the central bank’s task is to adjust monetary policy to reflect the higher real interest rates that naturally accompany higher expected rates of return on capital.

The Fed characterizes its current monetary policy as restrictive, meaning it will slow the economy below its 1.8% estimate of potential growth and reduce inflation to 2%. Its assessment is based on its current interest rate target of 5.25% to 5.5%, which is roughly 2.5 percentage points above the 2.8% core PCE inflation excluding food and energy. That is the highest inflation-adjusted rate since before the 2008-09 financial crisis and higher than Fed researchers’ estimates of the longer-run natural rate of interest, which they estimate to be roughly 0.5%.

But persistent economic strength calls into question whether current monetary policy really is restrictive and whether the natural rate of interest is so low. Real gross domestic product grew 3.1% over the past year, far higher than the Fed’s 1.8% estimate of sustainable potential growth. The unemployment rate, currently 3.7%, has remained well below the Fed’s 4.1% estimate of the longer-run natural rate of unemployment, or full employment. Consumer spending has been fueled by job growth and wage gains that are lifting disposable personal income. Soaring household net worth is raising the propensity to spend. Stimulative fiscal policies, including infrastructure spending and an array of tax credits, are increasing government and business investment.

Beyond these nuts and bolts of GDP growth are factors lifting productivity, such as technology, heightened labor mobility and business formation. Generative artificial-intelligence computing and machine learning are increasing efficiencies in healthcare, manufacturing, an array of service industries and social-media applications. Microsoft, Google and Apple are leading the AI boom, and Nvidia and other accelerator chip manufacturers are enabling it. Thousands of smaller firms and startups are developing and implementing AI applications. The rise in software and R&D as a share of total business fixed investment is transforming the U.S. economy.

Heightened labor mobility and work-at-home flexibility are increasing worker productivity and creating opportunities, while businesses are using labor more efficiently. Applications to establish businesses have climbed.

It’s premature to say that a sustained pickup in productivity is unfolding, but all the factors seem to be coalescing. At the same time, the labor force is near an all-time high and is certain to get a sizable boost from new immigrants. The combination points to stronger potential economic growth. This isn’t lost on the stock market, which is looking beyond the tired debate about recession versus soft landing and pricing in favorable longer-run prospects for the economy and profits.

The higher expected rates of return on capital have lifted real interest rates. We’ve seen this scenario before. In the 1990s, economic growth driven by a boom in productivity and strong labor-force expansion was accompanied by high real rates. Then, the federal-funds rate averaged 3% above inflation when real bond yields were high.

Fed researchers have estimated that the longer-run natural rate of interest has been in a decadeslong decline. That’s understandable. Following the 1990s, real interest rates were negative for most of the post-financial-crisis expansion while economic growth was lackluster and inflation below 2%. Following the pandemic, the Fed’s latest research reconfirmed low estimates of the longer-run natural rate of interest. Based on this, the Fed’s current thinking is that it will need to cut rates to avoid becoming inadvertently too tight. But the natural real rate is unobservable, and estimates of it are iffy. If the Fed’s assessment is wrong and real rates have risen, easing interest rates now would result in too-high inflation.

The Fed is wisely signaling that cutting rates now may be premature. The central bank can’t speculate. It needs to gain a better understanding of the supply side of the economy and how current innovations are affecting it, rather than focusing primarily on how monetary policy affects demand management.

The Fed has a poor track record of identifying real shifts in the economy. An exception was Chairman Alan Greenspan. In the mid-1990s, he correctly diagnosed the productivity boom and pushed back on colleagues who argued that raising rates was necessary because the low unemployment rate would push up inflation. Mr. Greenspan’s judgment extended the economic expansion.

High real interest rates and strong economic growth are positive complements. Today, the Fed needs to push back on calls to lower rates and instead learn more about how innovation is influencing real economic performance.

Mr. Levy is a visiting scholar at the Hoover Institution and a member of the Shadow Open Market Committee.

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