Federal Reserve Chairman Jerome Powell has suggested that the central bank is headed to a neutral rate of 2% to 3% for the federal funds rate.
With the Fed’s target for the rate now at 0.75% to 1%, that means another 1 to 2 percentage points of rate increases. But former New York Federal Reserve Bank President Bill Dudley said that likely won’t be nearly enough.
Powell was assuming inflation would come back down to the Fed’s 2% target, which would mean a real fed funds rate of 0% to 1% at neutral.
Dudley, now a senior research scholar at Princeton University, doesn’t expect inflation of 2% anytime soon. “Judging from the labor market, underlying inflation is running well above the Fed’s 2% target,” he wrote on Bloomberg.
He notes that average hourly earnings rose 5.5% in the 12 months through April. Assuming productivity growth of 1.5% to 2%, that implies inflation of 3.5% to 4%, and it could easily run higher, Dudley said.
Fed Funds at 5% to 6%
And that in turn suggests fed funds need to go much higher than 2% to 3%. “Now I’m 4% to 5% and it wouldn’t shock me if I’m 5 to 6 a few months from now,” Dudley said in a separate interview with Bloomberg
Deutsche Bank economists agree with him. They see the Fed having to raise the federal funds rate to 5% to 6% to get inflation under control. Consumer prices soared 8.3% in the 12 months through April.
The Fed has forecast a goldilocks outcome, where the central bank quells inflation and avoids boosting unemployment much or sending the economy into recession.
But rate increases, the Fed's balance-sheet reduction and the “financial upheaval that accompanies [them] will push the economy into a significant recession by late next year,” the Deutsche Bank economists wrote in a commentary.
No Mild Downturn
“Something stronger than a mild recession will be needed to do the job” of controlling inflation. They see unemployment ultimately rising by several percentage points. It totaled 3.6% in April.
The basic problem: “The scourge of inflation has returned and is here to stay,” the economists said, echoing Dudley. “While we may have seen the highs now, it will be a long time before [inflation] recedes back to acceptable levels near the Fed’s 2% target.”
Meanwhile, the Harvard economist and former Treasury Secretary Larry Summers has pointed out that in the past 65 years, every time that inflation has stood above 5% and unemployment under 4%, a recession has ensued within two years.
