America’s extraordinarily loose monetary policy continues to fuel excess demand, price inflation and financial asset valuations.

That shows that raising the U.S. Federal Reserve’s policy interest rate – the effective federal funds rate – from 0% to 5.07% since January 2022 is just a way station in the process of restoring price stability. One could also consider that as a thoughtful pause to test empirical research of what it takes to rebalance an economy destabilized by seriously misguided monetary policies over the last twenty years.

A re-accelerating aggregate demand during the first quarter, roughly stable employment and a core consumer price index (CPI corrected for energy and food prices) of 5.3% last May are all signs that the prevailing demand-supply gap in labor and product markets is not closing.

And that is an unmistakable indicator that the monetary policy is not doing its job of suppressing demand to the point of bringing price inflation down to its medium-term stability objective of about 2%.

The question is: What would it take to reach that policy target?

Going by the findings of scholarly research, there is a long and painful way ahead.

Keep plentiful energy supplies

Here is what that research says: We now have a slightly negative real effective federal funds rate of – 0.23% (federal funds rate of 5.07% minus the core CPI rate of 5.3%). That indicates an extremely loose credit policy stance.

To reach a neutral policy position, with a 5.3% inflation, the federal funds rate would have to be raised to 7.3%. In other words, that would be neither tight nor loose credit conditions. Any federal funds rate above 7.3% (again, assuming an inflation rate of 5.3%) would be moving toward varying degrees of restrictive monetary policy needed to suppress aggregate demand and bring inflation down toward a policy target.

Suppressing aggregate demand means a growth recession, rising unemployment and intractable political problems for the party in power. It’s a calamity the Democrats’ White House does not want in the run-up to an election year 2024.

But that’s what the economic theory says: it’s impossible to bring inflation down without creating a recession. The only possible choice might be the depth and the duration of the economic downturn. And that would depend on the magnitude of inflation and on the timing and degree of monetary tightening.

To make things simple, there are essentially two policy choices.

First, as we wrote in an earlier paper, the Fed and the White House may agree that -- for the time being -- a 5% inflation rate is acceptable, and that no further interest rate increases are necessary. To hold its part of the bargain, the Biden administration could continue to increase energy supplies to push gasoline and heating oil prices down as much as possible.

Free and fair trade with China

That’s what has been happening so far. And that accounts for the fact that the core CPI of 5.3% is significantly higher than the general CPI of 4%. Indeed, gasoline prices in May were down 19.7% from the year earlier, utility (piped) gas services fell 11%, and the fuel oil crashed a whopping 37%.

That sounds like there could be more election year goodies.

The next thing the White House may wish to do to keep inflation down is burry the trade hatchet with China. It would then have Canada, Mexico and China, the three largest trade partners, supplying goods and services at competitive prices to a steadily growing U.S. economy.

Under those circumstances, it could be possible to avoid interest rate increases that would create an economic slowdown and rising unemployment in an election year.

The second policy option is to continue tightening credit conditions.

That would be a mistake because it would significantly raise the probability of an irretrievable slowdown. At this point in the business cycle, it would be wise to pause to assess the lagged impact of past interest rate hikes, because there are no compelling reasons to rush into the next, and a more critical, phase of credit restraint.

America’s economic growth and sound financial markets are also crucially important assets at a time when Washington is facing increasing, and credible, challenges to its world order. A recession and tumbling Wall Street are things we can do easily with an undue haste to reverse structural problems that need time to subside and heal. So, leave that as a post-election issue.

With a Europe in disarray, and little else to lean on, Washington may wish to bear down on energy prices and to uphold free trade. That would raise the odds of keeping the economy on a growth path of non-accelerating inflation, and it would also contribute to preserving social cohesion during divisive political contests in the months ahead.