Neel Kashkari, Essay: Policy Has Tightened a Lot. Is It Enough? (An Update)

“The tightening cycle in 1994 might be a better benchmark because, as is true now, the FOMC at the time had a lot of credibility with the public, although inflation was not as high in 1994 as it is today. So it is not a perfect comparison either.”

“Minneapolis Fed staff’s best estimate is that when the FOMC raised the policy rate by 300 basis points in the 1994 tightening cycle, it translated into an increase of about 200 basis points in the 10-year real rate (Chart 5) to what was coincidentally also about 200 basis points above the then-neutral 10-year real rate. So that is the key: it seems as though policy drove the 10-year real rate about 200 basis points above neutral.”

“As I stated earlier, the underlying inflationary dynamics are quite different today than in 1994, so simply repeating the 1994 tightening might not be enough. We have done about half as much real tightening as in 1994, and we might need to do more.”

“Of course, we are also shrinking our balance sheet, which was not happening in 1994, and that is doing some work for us in terms of pushing up long real rates. But how much of the forecasted balance sheet runoff is already priced into long real rates is hard to know.”

“So while I supported increasing the federal funds rate by 75 basis points at this week’s meeting, and could support another such move in July, this uncertainty about how much tightening will be needed leads me to be cautious about too much more front-loading. A prudent strategy might be, after the July meeting, to simply continue with 50-basis-point hikes until inflation is well on its way down to 2 percent. Obviously, in such a scenario, the FOMC would still need to remain data-dependent and have the flexibility to account for economic developments that might arise.”

“If the shocks that are restraining supply begin to subside, then we may not need to raise long real rates as high as we would otherwise. In my most recent SEP submission, I assume that this will take place in 2023, allowing us to then relax policy somewhat in 2024.”