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Will the Fed Overdo It?

Although inflation has begun to fall, the US Federal Reserve is not satisfied with the current macroeconomic situation, implying that it would rather to do too much than too little. But with several problematic alternative scenarios coming into view, policymakers will need to remain acutely sensitive to new data.

CHICAGO – The US Federal Reserve is clearly determined to bring down inflation. But no one really knows how high it will have to raise its policy interest rate – and how long it will have to keep it there – to achieve its objective. Many are thus wondering whether the Fed will bring on a recession.

Inflation is coming down, partly because snags in supply chains have been sorted out, but also because demand is weakening. Higher interest rates have slowed home purchases, and hence housing construction. Higher-priced goods and services have eaten into household budgets and impeded consumer spending. And China’s anemic growth has dampened commodity prices globally.

The Fed, however, is not satisfied with the current situation. It fears that until some slack emerges in America’s red-hot labor market, wages could still catch up with inflation and then push it higher. The last thing the Fed wants is to hit pause and then see inflation ramp up again as financial markets celebrate and financial asset prices rise, reigniting demand. That would force policymakers to raise rates higher, and for longer. “One and done” would be far better than “rinse and repeat,” both for the economy and the Fed’s reputation.