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FAU Economist: Current Fed Policy Too Tight as Inflation Declines

amber-bonefont/abonefont@fau.edu | Mon, Sep 9, 2024

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With inflation coming in below target, the Federal Reserve is facing increasing pressure to adjust its monetary policy as many see it as too tight, according to an economist at Florida Atlantic University.

With inflation coming in below target, the Federal Reserve is facing increasing pressure to adjust its monetary policy as many see it as too tight, according to an economist at Florida Atlantic University.

The Federal Reserve’s preferred measure of inflation, the Personal Consumption Expenditures Price Index (PCEPI), grew at a continuously compounding annual rate of 1.9% in July, below the Fed’s 2% target. What’s more, the PCEPI has averaged just 0.9% over the past three months.

“While the Federal Reserve has signaled it would cut its policy rate this month, it is playing catch up,” said William Luther, Ph.D., associate professor in FAU’s College of Business. “The Fed has a long way to go to achieve a neutral policy stance. The current federal funds rate target range is 5.25% to 5.5%, with estimates putting the neutral policy rate between 2.7% and 3.2%.”

Ideally, the Fed would gradually reduce its nominal federal funds rate target as inflation falls to prevent monetary policy from passively tightening. As the economic policy is already too tight, given observed inflation in recent months, it will likely tighten further as inflation continues to decline unless the Fed course corrects quickly, according to Luther.

History suggests the Fed will move slower than the market currently projects.

“Fed officials were slow to react when inflation picked up in 2021, slow to reach a tight policy stance once they began raising rates in March 2022, and slow to respond to the disinflation experienced over the last year,” Luther said. “Absent a severe economic contraction, it is difficult to believe the Fed would now pick up the pace.”

Prices are still high despite lower inflation. In July, PCEPI was 8.8 percentage points higher than it would have been had the Fed hit its 2% inflation target since January 2020, according to FAU’s Monthly Inflation Report.        

-FAU-