Unwinding Pandemic Monetary Policy

Inflation, though, has reached the highest level in a generation. A part of this can be directly connected to current spending patterns — for durable goods especially — and the real disruptions we have seen in supply chains. Another piece is the war in Europe that has increased commodity prices sharply.

Of course, such shorter-run inflationary pressures are beyond the Fed's control. Indeed, monetary policy can at best only partially address some short-term price fluctuations stemming from supply disruptions, and even here, doing so requires anticipating when the causes of those shocks will cease. This is difficult to do in the best of times, and especially so as the economy uncoils after a pandemic. It's therefore important to avoid overreacting to real changes in prices that reflect real circumstances such as pandemic-induced plant closures or supply chain disruptions, allowing price signals to guide supplies to where they are scarce.

Yet, another part of inflation now appears clearly broader and more durable, suggesting a need to lower monetary policy accommodation. So, to execute on its commitment to its 2 percent target, the Fed is acting now to bring inflation down. It started by first shrinking the pace of its asset purchases, then by lifting interest rates away from near zero, and then by indicating that it will begin to sell off assets outright.

Of these steps, rates are the key. Taking into account both inflation and the strong labor market, the Federal Open Market Committee voted in early May to raise them by 50 basis points to a range of 0.75 percent to 1 percent, and, importantly, has indicated openness to further hikes as needed to tackle inflation. Long-term inflation expectations remain near target, suggesting that these policy moves will keep current inflation from persisting.

Will these moves to lower inflation create a recession? While there is always a risk, a variety of indicators suggest that by themselves, they will not. Instead, the moves so far are best seen as simply taking us toward a more "neutral" stance. Of course, such a neutral interest rate is a moving target in a turbulent world. So, as President Barkin has said, we want to move at a pace that allows us to assess and respond to conditions as they evolve.