The Fed Thinks It’s Fighting Inflation. Think Again.

To a large and under-appreciated extent, the job of the US Federal Reserve entails chasing an elusive number: r*, or the neutral short-term interest rate. When the Fed’s target rate is above r*, it should restrict growth. When it’s below, it should stimulate economic activity.

I think r* is a lot higher than the Fed recognizes — which means the central bank isn’t doing enough to fight inflation.

R* isn’t directly observable. It must be inferred from how the economy responds to short-term interest rates. This isn’t easy, for three main reasons. First, the impact of short-term rates depends on other financial phenomena such as long-term rates, stock prices and credit spreads – all of which vary considerably on their own. Since October, financial conditions have eased significantly even as the Fed has held short-term rates steady. Second, rate changes operate with long and variable lags: It’s possible, for instance, that the full effects last year’s Fed tightening have yet to be felt. Third, there’s always a lot going in the economy other than monetary policy — such as, right now, a wave of investment in artificial intelligence.

Still, r* is too important to ignore. A judgment must be made, to assess where the Fed stands and what it needs to do. And lately, officials’ approach hasn’t been compelling.