Bill Dudley: I think r* is a lot higher than the Fed recognizes —

which means the central bank isn’t doing enough to fight inflation.

 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.

R* isn’t directly observable. It must be inferred from how the economy responds to short-term interest rates.

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.

Chair Jerome Powell has mostly pushed back against r* questions at his press conferences. The Fed’s median projection of r* (adjusted for 2% inflation) has hardly budged in years

There’s a strong case that r* has risen substantially. For one, the persistent strength of the US economy suggests that monetary policy isn’t very restrictive. 

Put it all together, and r* could be as high as 2%, which was the conventional wisdom prior to the 2008 financial crisis (embodied in the Taylor Rule

If so, the neutral short-term rate currently would be about 5% (a 2% r* plus 3% inflation), meaning that the current fed funds rate of 5.25% to 5.50% is exerting negligible restraint on growth and inflation.

Bill Dudley Bloomberg 30 maj 2024

https://www.bloomberg.com/opinion/articles/2024-05-30/federal-reserve-inflation-fight-might-be-a-miscalculation


When I first developed the Taylor rule, which has been widely discussed for three decades now, I based it on an average inflation rate

https://englundmacro.blogspot.com/2024/03/at-some-point-this-year-interest-rates.html


 

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