After more than a decade of excessively loose policies, the U.S. monetary authorities (the Fed) decided early last year to “normalize” credit conditions and restore price stability.

During that period, the policy interest rate – formally known as the effective federal funds rate -- has been raised from 0% to 5.33% at the close of trading last Friday, September 29, 2023.

That is a powerful shock to credit costs and asset values determining private consumption, residential and business investments – representing 90% of American economy.

A lot is at stake. And, arguably, this is the most difficult point in this credit tightening cycle to decide how far not to go too far.

What is the difficulty?

We don’t know with any degree of certainty how long it takes for changes of monetary policy to affect economic activity. And we know much less about the magnitude of policy change needed to produce the desired change in economic activity and price inflation.

There are no rules – it’s visual navigation

All we know is that the monetary policy operates with long- and variable-time lags. Empirical estimates show that it can take two to six quarters between the time of a monetary policy change and its impact on demand, output and prices.

And then, we don’t know ex ante how that policy impact will be split between prices (i.e., inflation) and volumes of economic activity.

With all those uncertainties, die-hard monetarists are quipping that monetary authorities are “flying blind.” Their final verdict is that all booms and busts are caused by maintaining a monetary stimulus, or a credit crunch, well past the point where the economy needs them.

What are those die-hard monetarists advising?

They want the central banks to stop discretionary policy changes because they don’t know where the economy is at the time of a contemplated policy change, and they know even less where the economy will be at the time when the policy change begins to hit prices and volumes of economic activity.

So, the advice is: Set a growth rate of a monetary aggregate closely related to changes of economic activity and keep it there.

The Fed tried such a monetary targeting in late 1970s. The experiment was soon abandoned owing to an unstable relationship between the targeted monetary aggregate and the key macroeconomic variables. Eventually, that also led to monetarists’ concession that the instability of their monetary rule was much greater than they anticipated.

All that discussion was offered to demonstrate the difficulty of deciding what the Fed should do next. And the best way to see that difficulty is to look at America’s economic growth, unemployment and inflation.

Pause, observe – and stay out of election year clashes

After interest rates began to rise last year, the U.S. GDP growth weakened at an annual rate of 1.2% in the second half of 2022. In last year’s fourth quarter, the GDP growth even collapsed to 0.7%.

But then, suddenly, the GDP growth shot up to 1.7% in this year’s first quarter and accelerated to a 2.4% growth in the second quarter – showing no significant depressive impact of a sharp interest rate increase over the previous twelve months.

What happened?

The impact of monetary tightening was blunted by a fast-acting boost of government spending – accelerating from a 0.8% annual growth in last year’s fourth quarter to 4.1% in this year’s second quarter.

Unsurprisingly, employment, a lagging activity indicator, held up quite well, and then increased sharply between July and August, reflecting faster GDP growth and increasing labor demand.

Similarly, various measures of core inflation indicators (corrected for prices of food and energy) have shown very little movement, staying literally stuck in the 3.6% to 4% range.

That’s what the Fed is looking at now. And the question is whether the White House, facing a difficult election year outlook, will be able to continue its spending spree observed since the third quarter of last year.

Most probably, the White House will try, but the opposition (i.e., Republican) controlled House of Representatives is unlikely to cooperate. The high cost of credit will then continue to erode interest rate sensitive components of aggregate demand.

That’s already happening. The residential investment has been collapsing at an average annual rate of 16% since the summer of last year. When that happens, consumption of consumer durable goods (home furnishings) also takes a dive. And business investments inevitably slow down because weakening sales can be met from existing production capacities.

The Fed is, therefore, wise to pause and observe to avoid a monetary overkill. Apart from that, it’s always advisable for the Fed to stay out of the way during an election year.