Last week the Federal Reserve made a long-awaited and very welcome announcement. They decided not to raise interest rates again right now. Not only that, but they announced their expectation that interest rates will be allowed to fall over the next few years. That suggests that the country’s monetary policy has reached a significant turning point.
The goal of the Fed’s long series of rate increases was to curb inflation by discouraging borrowing and spending. While the stated goal of only 2% inflation has not quite been reached, so much progress has been made that the Fed now expects the economy to get there without such a tight-money policy.
When I say “the Fed expects,” that refers to the published projections summarizing the opinions of Federal Reserve Board members and Federal Reserve Bank presidents. The publication reports a median projection for each key variable by ranking the individual projections from lowest to highest and finding the middle. This month’s median projection for the federal funds rate—the key short-term interest rate—expects it to be 0.8% lower in 2024 than in 2023 (4.6% vs. 5.4%).
When the Fed raises interest rates to fight inflation, that always arouses some fear of a “hard landing.” High interest rates may discourage borrowing and spending so much that the economy contracts and unemployment rises. Currently the Fed expects unemployment at only 4.1% for 2024, not far from the 3.8% in 2023. The combination of low inflation and low unemployment is exactly what the Fed wants to achieve. It would be a rather rare “soft landing.”
How the Fed does it
The primary tool of the Federal Reserve’s monetary policy is its control over short-term interest rates. That means mainly the federal funds rate, which is the rate banks pay to borrow from one another. The actual federal funds rate depends on the supply and demand for funds in the market, but the Fed can influence it in various ways. It can change the rate of interest it pays on funds that banks hold in reserve, or the rate it charges on loans to banks.
The Fed also has some influence over longer-term interest rates, such as those paid on treasury bonds, business loans and mortgages. These tend to be higher, since lenders want their return to compensate them for the risks of a longer loan. But long-term rates also reflect expectations about the future of short-term rates. Banks are more willing to make long-term loans at low rates if they expect the interest they can earn from their short-term reserves to remain low for some time. That means that the Fed can influence long-term rates through what’s called “forward guidance”—announcements about where it expects short-term rates to go.
In recent years, the Fed has also influenced long-term rates by either buying or selling bonds. During the Great Recession of 2007-2009, the Fed’s purchases of treasury bonds and mortgage-backed securities maintained a liquid market for those loan instruments and helped the Treasury and homebuyers borrow at reasonably low rates.
Prior landings, hard and soft
The classic case of a hard landing occurred in the early 1980s. The runaway inflation of the 1970s led the Federal Reserve under Paul Volcker to raise interest rates vigorously. By January 1980, the federal funds rate stood at 15%, and it continued to rise even as the economy contracted. According to Ben Bernanke’s new book, 21st Century Monetary Policy, “Inflation dropped from about 13 percent in 1979 and 1980 to about 4 percent in 1982, where it stabilized for the rest of Volcker’s time at the Fed.” But the price was high. Unemployment rose to over 10%, the highest rate seen since the Great Depression. High interest rates were especially hard on the housing industry.
Fortunately for President Ronald Reagan, the economy recovered enough by 1984 to help him get reelected. He may have gotten some of the credit for inflation reduction that economists mostly give to the Federal Reserve. Although Reagan had promised to curb federal spending and balance the budget, his increased defense spending and tax cutting impeded those goals. The responsibility for inflation fighting fell mainly to the Fed.
During the economic expansion of the 1990s, the Federal Reserve under Alan Greenspan managed inflation concerns more smoothly. The federal funds rate rose in the mid-90s, but only to about 6%. To quote Bernanke again, “Between 1994 and 1996, Greenspan helped the U.S. economy make a soft landing, meaning the Fed tightened policy enough to restrain inflation but not so much as to cause a recession.” While Ronald Reagan had survived a hard landing because of its timing, Bill Clinton benefited from the soft landing.
The Fed’s long-run goal
How does the Federal Reserve decide what the federal funds rate should be? In recent years, monetary policy has relied heavily on the concept of the “neutral interest rate,” defined as the rate that is associated with neither rapid inflation nor high unemployment. The Fed can raise rates to curb inflation or lower rates to reduce unemployment, but the ideal state of affairs is when it can keep the rate neutral.
In recent years, the Fed has lowered its estimate of the neutral rate. Ten years ago, it thought that the federal funds rate needed to be over 4% to maintain low inflation and low unemployment. Now it pegs the neutral rate at only 2.5%. I won’t get into the interesting question of why the thinking has changed. But the change is important, because it reveals where the Fed wants to go with interest rates. It means that the Fed will not maintain today’s high interest rates indefinitely as a hedge against future inflation. It will bring them down as soon as it can, to avoid economic contraction and high unemployment. That suggests that the Fed is taking seriously both sides of its “dual mandate” to fight inflation and unemployment.
Of course, current expectations could still be invalidated by some new spike in inflation, especially if caused by supply shocks the Fed cannot control. Without such unforeseen events, however, the Fed seems poised to loosen the reins a bit. That bodes well for the economy, and maybe for Joe Biden too.
Posted by Ed Steffes 
Beneath the Surface 