The Fed’s Latest Problem: A Strong Economy

livemint.com:

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.