If inflation’s falling and central banks don’t cut rates, what happens?

Well, the real policy rate becomes more restrictive. Or less accommodative.

That, more or less, was the argument for cutting rates in the lead-up to the latest Fed easing cycle. Inflation receded, but Fed funds was left unchanged. The mathematical result was “passive” tightening.

In the summer of 2024, the real policy rate using underlying price growth on the Fed’s preferred inflation metric was 2.5%. The Fed stopped hiking a year previous, but policy was becoming incrementally more restrictive as inflation abated.

Fast forward two years, and the opposite dynamic’s in play. The Fed stopped cutting in December, but as the figure below shows, the real policy rate’s still falling because inflation’s on the rise amid the war with Iran.

As of the last PCE prices update from the BEA, the real policy rate’s just barely positive. One cut — or a 25bps increase in annual core PCE inflation — and it’d be zero.

Is that bad? Not necessarily, but you do have to think about the read-across and the potential ramifications for an economy that isn’t behaving, at the aggregate level anyway, like it’s being held back by restrictive policy.

The dynamic’s obviously more pronounced when you use headline PCE prices rather than core.

As the figure shows, inflation-adjusted Fed funds was 75bps give or take in January. Now, it’s slightly negative.

Bringing in the neutral rate discussion, consider that the FOMC’s r-star guesstimate (i.e., the long run dot minus the 2% inflation target) is 1.1%.

The figure below shows you the history of SEP r-star and the real policy rate using headline PCE prices.

It’s possible the long run marker will move up in this month’s SEP refresh, but even using the March SEP, the FOMC’s collective attempt to geolocate the real neutral rate puts r-star well above both the core and headline PCE-implied real funds rate.

This isn’t lost on Fed officials, particularly hawkish Committee members. “The real policy rate is below the FOMC’s notion of long run neutral,” Alberto Musalem remarked, during a keynote address at the Reykjavik Economic Conference late last month.

“Inflation is running meaningfully above target and longer-term inflation expectations have been creeping higher,” he went on, before gently suggesting that “caution seems warranted in the face of upward inflation pressures from both supply and demand forces.”

He’s pounding the table on this. A month previous, for example, Musalem said the Fed needs to be “watchful” regarding “the risk that rising inflation inadvertently eases financial conditions.”

As to whether a prospective AI-driven productivity boom will be an inflation panacea, Musalem seems to doubt it.

“I’m an avid user of AI [and] I see the tremendous impact that it can have on businesses and households,” he said in Iceland. “[But] I believe it would be risky to rely on the prospect of higher productivity growth in the future to solve our inflation problem today.”