The binary aspect of monetary policy is problematic. That is, monetary policy is a blunt tool that can be directed at either stimulating economic activity or suppressing it. The Federal Reserve Board, which directs this policy, has a number of mechanisms at its disposal, but essentially those tools fall under three alternative policy choices: easing monetary policy, tightening, or maintaining a neutral stance.

Easing means accelerating the pace of monetary expansion with the corollary of lowering interest rates; tightening means retarding the growth of monetary expansion with rising interest rates; and taking a neutral stance allows interest rates to change because of market forces independent of Fed policy initiatives.

In theory, it's actually quite simple. Given the Fed’s dual mandate to achieve price stability and full employment, the Fed is charged with responding when the economy deviates from a desired path – i.e., when either inflation or unemployment become unacceptably elevated.  Tightening monetary policy would be required to rein in excessive inflation, while easing monetary policy would be needed to stimulate economic activity to bring unemployment lower. At any time, the Fed can do one or the other, but not both. 

Starting in early 2022 when inflation measured by year-over-year changes in consumer prices surpassed 7.5 percent, fighting inflation became the Fed’s clear and obvious policy priority. Since that time, the Fed has raised its target for the Federal Funds interest rate – a key monetary policy indicator -- on 11 separate occasions with the stated goal of ultimately bringing inflation down to a pace of 2 percent per year.  At its peak (June 2022), this measure of inflation reached 9.5 percent, but the latest reading (May 2024) was just 3.3 percent.

The most recent adjustment to the Fed’s target for the Federal Funds rate was made in July of 2023, suggesting that, while still short of its 2 percent goal for inflation, the Fed has taken more of a neutral stance, waiting to see if its prior actions would have their effect with a lag all the while reserving the prospect for raising interest rates further if necessary – i.e., if the Fed sees inflation and/or inflationary expectations starting to move higher. It’s also likely that as long as the Fed can point to at least some signs of progress on taming inflation, it can avoid raising interest rates further, hoping to continue to see inflation ebbing without pushing the economy into a recession.

These worries notwithstanding, the calculus seems to be at risk of changing with the release of the latest Department of Labor’s report on job growth and unemployment rates.  Despite a stronger than expected increase in jobs being created, the latest data (covering May 2024) reflect a slight uptick in the unemployment rate, coming in at 4 percent. While still low from an historical perspective, this rate had been as low as 3.4 percent during the first half of 2022.

The bind for the Fed is that it doesn’t want to see inflation accelerate, nor does it want to see unemployment rates move higher; but taking any prophylactic action to mitigate either of these risks would probably exacerbate the other, leaving the Fed in the position where it will likely try to sit tight until one of these problems develops into something more concerning.  The nightmare scenario is that conditions deteriorate on both fronts.  Thankfully, the dilemma is not yet confronting us (or the Fed) . . . but, in time, it could.

The unanswered question is this: What are the trigger levels of inflation and/or unemployment that would cause the Fed to prioritize addressing one problem over the other?  Unfortunately, it’s complicated – particularly if both measures deteriorate simultaneously. Thus far, with the unemployment rate staying below 4 percent, it has been easy for the Fed to target taming inflation as its policy priority, but that policy choice will get harder if (or when) the unemployment rate becomes more elevated. Similarly, the Fed’s appetite to try to reduce unemployment if that metric were to creep up would likely be compromised if a resurgence of inflationary pressures starts to develop.

Added to the mix is the reluctance that the Fed must feel about the inevitable criticism that would likely come to bear if the Fed were seen to be giving up on its commitment to bring inflation down to 2 percent.  Failure to make good on that commitment could unleash inflationary expectations that have thus far been contained; and once that genie is out of the bottle, success in fighting inflation would become considerably harder. Fingers crossed.

While some Fed observers still fault it for waiting too long to initiate its tight money policy back in 2022, my assessment is that that criticism is a cheap shot.  As is the case with any time-series data (e.g., prices, interest rates, inflation rates, etc.), it’s difficult to discern with any high degree of confidence whether a perturbation in the data reflects the onset of a trend or noise in the data that would soon be reversed.  Given this inherent uncertainty, the Fed’s reticence to commit to a policy of tightening too quickly seems eminently reasonable to me; and the Fed’s commitment to be guided by additional data as they develop seems as appropriate now as it was then. Thus far, this orientation has served us well.