Post by Tsvetomir P.

After a full year of monetary tightening, high inflation remains headline financial news. Although the latest CPI report shows consumer prices fell just below 6% YoY, it is important to note that this number is not only still much higher than desired but that it also stands on an already high base of 8% YoY (Feb '22). On the other hand, the labor market continues to perform strongly with both initial and continued claims at a low and steady level. Compared with my small-scale model economy, the real economy is responding to interest rate hikes “unexpectedly” thus far. There are at least several good reasons why that could be the case. It might be that variables with strong explanatory power outside of interest rates are unspecified. The real economy is still turbulently adjusting to a pandemic, monetary and fiscal stimulus, oil price shocks, and supply chain disruptions, on top of growing geopolitical pressures and an ongoing war. My model results are not a forecasting attempt but provide useful inference regarding the average effect of an interest rate increase on the observed variables over the observed timeframe. Further, it is important to note the distinction between short- and long-run effects. In macroeconomic terms, we are still well in the short-run and might want to shift our focus to the longer-run instead. Historically, a single change in the interest rate takes up to a year until fully translated and, in the current state of the economy, it will probably take longer. This means that as other shocks settle, the effects of a monetary contraction will necessarily be felt, at least directionally, but quite possibly with a strong impact also. Even though the primary focus remains on inflation and the labor market (the central bank follows a dual mandate), hikes are felt in other parts of the economy also, especially the stock and bond markets which respond contemporaneously and can be indicative of the economic outlook ahead (e.g., recent banking scares exemplified the effects of rapid bond rate changes on solvency of the overinvested in pre-tightening bonds). All of this to say that “soft landing” sounds quite difficult to engineer. With another funds rate increase expected in a few days, it is difficult to determine whether policymakers are acting optimally. That said, if interest rates are to produce negative impacts for the real economy, any new increases are going to exacerbate those further. #inflation #monetarypolicy #federalreserve