Anticipating the Federal Reserve’s moves is tough because the U.S. central bank has not effectively articulated the challenges it faces.

Monetary policy features famously long lags that change from one business cycle to another. Much depends on structural changes in government finances and the private economy, external shocks that instigate recessions or inflation, and how quickly the Fed responds.

After the 2008 global financial crisis (GFC), for example, it took eight years for the U.S. economy to reach full employment, and the federal deficit was 3.1% of GDP. Now, with the economy fully recovered from the COVID-19 pandemic, the Congressional Budget Office projects the federal deficit this year will be 6.7% of GDP. That’s a lot more fiscal stimulus and it requires greater monetary restraint to keep inflation in check.

Larger federal deficits place more demands on available capital. With the national debt zooming, bond investors should require higher interest rates to offset the risks that Washington could inflate its way out of its large debt service burden.

Artificial Intelligence and reducing carbon emissions — switching to electric vehicles, heating for building and appliances, and wind and solar for generation — require substantial additional capital too.

Consequently, many economists believe that real r*, the inflation-adjusted rate of interest that neither curbs growth nor accelerates price increases, is higher now than the decade prior to the pandemic. A good estimate of the social cost of capital is 2%, or the real potential rate of growth in the economy.

Inflation, while improved, remains significantly elevated. In May, the U.S. Consumer Price Index was up 3.3% from a year earlier. The pace of new home construction is slower than before the GFC owing to more limited supplies of buildable land near metropolitan employment centers. Even with high mortgage rates, U.S. home prices are rising at a 7.2% annual pace.

When inflation started heating up in 2021, both Fed Chair Jerome Powell and the Biden Administration told us inflation was temporary. The Fed procrastinated for a year before raising interest rates. The Fed has not expressed remorse for how much that delay ultimately juiced consumer spending and inflation when COVID shutdowns ended.

Even now Powell keeps telling us inflation expectations are well anchored, but those are hardly anchored at 2%. Household surveys conducted by the Conference Board, New York Federal Reserve and University of Michigan put expected inflation at 3% to 4%.

Higher inflation expectations reflect a loss in confidence that the Fed can adequately tame inflation or that the current cast of monetary and fiscal policymakers are prepared to do what it takes. Elevated inflation expectations put nominal r*, the observed interest rate that would neither slow the economy nor further accelerate inflation, at 5% to 6%.

Currently, the target federal funds rate is 5.375%. Fed policymakers currently project the long-term federal funds rate to be about half of that — 2.8%. Simply put, Fed policymakers appear to have lost touch with economic reality. If anything, interest rates should stay where they are or be raised in order to bring down both actual and expected inflation.

The U.S. economy should now slow, because the ability of most consumers to absorb higher prices is flagging as their extra savings, piled up during the pandemic, have run out.

High-income households with large wealth positions in stocks and fixed income investments have enjoyed surges in non-wage income. But for most others, downward adjustments in spending are needed since their capacity to pile up debt is limited.

Past battles with inflation would indicate that if the Fed lowered rates before reaching its 2% goal, inflation would accelerate again, and inflation expectations would rise further and harden. The situation would devolve into a cycle of tightening to curb inflation, then loosening to boost employment, with inflation ratcheting up to successively higher levels. Those were the conditions in the 1970s — before then-Fed-Chair Paul Volcker was forced to take Draconian steps to defeat “The Great Inflation” that afflicted the U.S.
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Peter Morici is an economist and emeritus business professor at the University of Maryland, and a national columnist.