Faced with only limited signs of a slowdown in US demand despite more than five percentage points of interest-rate hikes, logic would say the Federal Reserve needs to do more.
But policymakers and Fed watchers are now giving more attention to a new line of argument, that central banks need to take account of what their actions mean for the supply side of the economy. The implication: Too-high rates could actually undermine the inflation fight, by squelching the benefits of increasing supply — which are just now coming on stream.
Evidence shows that interest-rate surges affect financing conditions and the appetite for risk, constraining the supply side of the economy by inhibiting innovation, Yueran Ma and her co-author Kaspar Zimmermann found in the paper. Powell will have the opportunity of discussing the two dynamics on Wednesday, in his press briefing following the Fed’s latest rate decision and policymakers’ updated projections for the benchmark rate. Economists anticipate no change in rates this time, with the potential for officials to pencil in one more move later this year.
It’s a policy paradox for the Fed to consider the role of allowing moderate growth — rather than sharply braking it — in order to get inflation sustainably back to its 2% target over the next few years. But that’s the implication of the new research. Traditionally, supply was thought to be more a story about the economy’s bedrock structures — like population growth or energy endowments, which are less affected in the short term by the cost of money.
“This post-crisis experience suggests that changes in aggregate demand may have an appreciable, persistent effect on aggregate supply — that is, on potential output,” she said. “The natural next question is to ask whether it might be possible to reverse these adverse supply-side effects by temporarily running a ‘high-pressure economy,’ with robust aggregate demand and a tight labor market.”
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