{T} he Federal Reserve will almost certainly leave its interest-rate target range unchanged at this week’s Federal Open Market Committee (FOMC) meeting. Markets currently put the odds of a rate cut at a mere 3.1 percent. FOMC members should think carefully about that decision. New data from the Bureau of Economic Analysis shows that inflation has fallen faster than FOMC members expected, which implies that monetary policy was tighter than FOMC members thought. To keep monetary policy on its intended path, the FOMC should begin cutting its interest-rate target range.

Monetary Policy in Theory and Practice

The conventional view of monetary policy maintains that the Fed adjusts interest rates to determine the stance of monetary policy. Monetary policy is loose when the real (i.e., inflation-adjusted) federal funds rate is below the natural (or, neutral) rate. Monetary policy is tight when the real federal funds rate is above the natural rate. Correspondingly, the Fed loosens policy by reducing the real federal funds rate relative to the natural rate and tightens policy by increasing the real federal funds rate relative to the natural rate.

Setting the stance of monetary policy is easy in theory, but difficult in practice. For starters, the natural rate of interest is unobservable and might bounce around from period to period. The New York Fed offers two estimates of the natural rate. Its Laubach-Williams estimate was 1.9 percent for Q3-2023. Its Holston-Laubach-Williams estimate was 0.88 percent. The Richmond Fed also estimates the natural rate. Its Lubik-Matthes estimate was 2.17 percent for Q3-2023. That’s a broad range of estimates, and the range is even bigger when confidence intervals are included.

Another difficulty stems from the need to determine the real interest rate. The FOMC cannot directly target the real interest rate, which depends on inflation that has not yet occurred at the time when the Fed is setting policy. Instead, it indirectly targets the real interest rate by directly targeting the nominal interest rate. The expected real interest rate is equal to the nominal interest rate minus expected inflation. The actual real interest rate is equal to the nominal interest rate minus actual inflation. When actual inflation differs from the rate of inflation that FOMC members expected, the actual real interest rate differs from the real interest rate FOMC members had hoped to deliver when setting their nominal interest rate target.

To see why this matters, consider what happened in late 2021 and 2022. FOMC members chose their nominal-interest-rate targets with an expectation of how inflation would evolve given those targets. In hindsight, it is clear that their expectations of inflation were too low. Correspondingly, the real interest rate they actually delivered was much lower than the real interest rate they thought they were delivering. Monetary policy was too loose, and inflation surged:

Monetary Policy at Present

It seems FOMC members are now erring in the opposite direction. As before, they have chosen a nominal-interest-rate target path with an expectation of how inflation would evolve. But inflation has been lower on average over the last couple months than FOMC members anticipated. That means the real interest rate they have been delivering is higher than they thought. If they do not course correct quickly, a painful recession could follow.

In December, FOMC members projected the Personal Consumption Expenditures Price Index (PCEPI), which is its preferred measure of inflation, would grow 2.7 to 3.2 percent in 2023, with a median projection of 2.8 percent. At the time, FOMC members had data through October, which showed inflation had averaged 3.0 percent year-to-date. However, that data also showed that much of the inflation had occurred early in the year: Inflation had averaged just 2.3 percent over the six-month period ending in October. FOMC members were implicitly projecting that inflation would continue to decline at a steady pace: PCEPI inflation would have needed to average 2.0 percent in November and December to meet the median FOMC member’s projection.

In fact, PCEPI inflation averaged just 0.6 percent in November and December, 1.4 percentage points below the median FOMC member’s implicit projection. That brought the annual inflation rate down to 2.6 percent — below the range of FOMC member projections.

Recall that the expected real interest rate is the nominal interest rate minus expected inflation. The FOMC’s nominal federal funds rate target range was 5.25 to 5.5 percent in November and December. Given the implicit 2 percent inflation projection for these two months, they were intending to deliver a real interest rate in the range of 3.25 to 3.5 percent. The lower bound of that range is 1.08 to 2.37 percentage points above conventional estimates of the natural rate. Hence, monetary policy was intended to be tight in November and December even though inflation was projected to be back at 2 percent.

In fact, monetary policy was even tighter than the median FOMC member intended. Recall that the actual real interest rate is the nominal interest rate minus actual inflation. Since actual inflation averaged 0.6 percent in November and December, the FOMC actually delivered a real interest rate in the range of 4.65 to 4.9 percent. The lower bound of that range is 2.48 to 3.77 percentage points above conventional estimates of the natural rate. Hence, monetary policy was much tighter than intended.

Conclusion

FOMC members were late to recognize rising inflation in 2021 and slow to begin tightening in 2022. It is understandable that they do not want to make that error again. But mistakes in the opposite direction are also mistakes, which should be avoided when possible.

The Fed tightened monetary policy in 2022 and 2023 and brought inflation back down to 2 percent. One might argue that Fed officials should have cut their federal funds rate target in December 2023. Their projections reveal that they thought inflation would be back on track. And yet they intended to deliver tight monetary policy.

Regardless of what one thinks of the decision to keep rates high in December, however, it is much more difficult to argue that they should keep rates high now. Monetary policy has been tighter than FOMC members intended. They must cut their nominal interest-rate-target range just to prevent real rates from rising further. Otherwise, monetary policy will continue to tighten, and real economic activity will decline.