The National Bureau of Economic Research (NBER) recently published a paper co-authored by the University of California, Berkeley’s Christina and David Romer, titled “Does Monetary Policy Matter? The Narrative Approach After 35 Years.”
The economists examined the various post-war monetary shocks and assessed their effects on expanding and contracting conditions of the national economy.
Since the Second World War, the primary monetary shocks have been changes in the quantity of money traveling through the economy, adjustments to short-term interest rates, fluctuations in credit availability, and volatility in exchange rates. These instances can hurt the economy, such as interest-rate hikes resulting in falling employment or contracting output.
But while these significant changes can affect the economy, the size and scope could be exacerbated or minimized based on other factors, including how the Federal Reserve (Fed) responds to the effects, the health of the national economy, and behavior in the financial markets.
At the same time, how the central bank conducts monetary policy could also have a critical role in mitigating the negative effects of recessions.
Since the Fed launched its quantitative tightening cycle—a blend of rate hikes and balance sheet reductions—the U.S. economy has experienced all four of these developments. These efforts have seen the benchmark federal funds rate climb by 475 basis points to its highest level since before the 2008 financial crisis.
Challenges Ahead for the Federal Reserve
What will these monetary shocks mean for the present economy?The first is that achieving lower inflation will take at least another year.
“Based on the historical point estimates, to get inflation down just through the conventional effects of contractionary monetary policy is likely to take at least another year,” the paper stated.
In March, the personal consumption expenditure (PCE) price index, which is the Fed’s preferred inflation measurement, eased to 4.2 percent, the lowest since May 2021. This is still double the central bank’s 2 percent target rate.
Core PCE, which strips the volatile food and energy sectors, slowed to a higher-than-expected 4.6 percent.
The next issue ahead is that unemployment levels will gradually increase over 2023.
“The second thing that our analysis of monetary shocks in the past suggests is that as of January 2023, the effects on unemployment are likely yet to come,” the economists noted. “At six months after a shock, which is where January 2023 stands relative to the tentatively identified shock in July 2022, unemployment normally would not have begun to rise. If the historical pattern holds, the effects on unemployment would develop gradually over 2023.”
The jobless rate presently stands at 3.5 percent.
Fed officials anticipate the unemployment rate rising to 4.5 percent this year and then 4.6 percent in 2024 and 2025, SEP data confirmed.
According to the NBER working paper, the third challenge for monetary policymakers is deciding when to stop rate hikes or begin the pivot.
Since the effects of the tighter policy will be realized for many months following the end of the hiking cycle, the economists warn that if the central bank continues to raise rates until inflation declines to the target levels, “they will likely have gone farther than they need to.”
“But policymakers are going to need to dial back monetary contraction before the inflation problem is completely solved, if they want to get inflation down without causing more pain than necessary,” they wrote.
“Based on the empirical estimates of the effect of previous shocks, one would expect substantial negative impacts on real GDP and inflation in 2023 and 2024,” the paper said.
