08-01-2024
The Federal Reserve at its July meeting decided to make no change to its policy rate. This makes it a year since the Fed has changed its policy rate. The Fed would seem to be holding steady its monetary policy to fight inflation.
It is important, though, to understand that no change in the Fed’s policy rate is not the same as no change in monetary policy. Monetary policy depends on the real policy rate, not on the nominal policy rate. The real policy rate is the nominal policy rate minus a measure of underlying inflation. Higher real policy rates restrict the economy while lower real policy rates stimulate the economy.
At its July meeting in 2023, the Fed raised its nominal policy rate to the current range of 5.25 to 5.50 percent. At that time, core PCE inflation was 4.2 percent. If we use core PCE inflation as our measure of underlying inflation, this means that the real policy rate in July 2023 was in the range of 1.05 to 1.3 percent. The latest core PCE inflation rate prior to the current Fed meeting was 2.6 percent. This implies that over the past 12 months the real policy rate has risen to the range of 2.65 to 2.9 percent.
That is, while the Fed has left its nominal policy rate unchanged, monetary policy has become more restrictive with the real policy rate, which is now more than twice as high as in July 2023. Far from holding monetary policy steady, the Fed has been tightening monetary policy as underlying inflation has abated. An important question is whether this is the right strategy for the Fed to engineer a soft landing for the U.S. economy?
Joseph Tracy is a Distinguished Fellow at Purdue University’s Daniels School of Business and a nonresident senior fellow at the American Enterprise Institute. Previously he was executive vice president and senior advisor to the president at the Federal Reserve Bank of Dallas.
