Bill Dudley: Will the Fed go longer or higher? Maybe both

How will the US Federal Reserve wage its battle with inflation - by keeping interest rates elevated for longer, or by taking them even higher? Investors are fixated on this question, which has vast implications for bonds, stocks and the entire economy.

Longer would be better. But if financial markets don't cooperate, the Fed might have to go higher, too.

By tightening monetary policy, Chair Jerome Powell wants to restrain demand for labor just enough - but not too much - to bring wage growth down to the 3%-to-4% level consistent with the central bank's 2% inflation target. To that end, the best approach would be to hold interest rates at a moderately restrictive setting for a significant period of time. Given that rate hikes affect the economy with long and variable lags, this reduces the risk of going too far and increases the chances of a soft landing. The Fed can take its time as long as inflation expectations remain well-anchored.

But here's the rub: It's hard to know what a moderately restrictive rate would be. Economists can't even agree on the threshold - the "neutral" rate that neither stokes nor cools the economy. Before the 2008 financial crisis, they guessed that it was about 2%, adjusted for inflation (or about 4% in non-adjusted terms). Now, the median estimate among Fed policymakers is 0.5% (or a nominal 2.5%, assuming 2% inflation) - but there's ample reason to think it should be higher as the government borrows more, the green-energy transition increases investment demand and retiring baby boomers save less. And with inflation exceeding the Fed's 2% target, the nominal neutral rate should be higher still.

Also, the impact of monetary policy depends in part on how it influences broader financial conditions, which aren't particularly tight. Stock and bond markets have remained buoyant as investors, encouraged by the Fed's downshift to 25-basis-point rate hikes, look beyond the present to what they hope will be a more accommodative regime in 2024 and 2025. The more bullish they are, the higher the neutral federal funds rate will need to be.

What's more, investors aren't particularly concerned about a bad outcome. Crypto meltdown aside, they see the financial system as resilient and the Fed as well-equipped to mitigate any economic downturn - a sentiment that Powell has endorsed by saying that if the Fed feels it has gone too far, "we have tools that would work on that."

So what will the Fed do? Most officials expect that a federal funds rate of 5% to 5.25%, maintained into 2024, will be enough to get inflation under control, and last week's jobs report reinforced that view. Hence, they'll probably opt for two more 25-basis point increases at their policy-making meetings in March and May.

After that, they'll wait and see what happens, an assessment that will take several months (at a minimum) given the long lags of monetary policy. To prevent financial conditions from easing further, they'll maintain their hawkish messaging, saying that monetary policy will remain tight for some time. And if a 5%-plus rate doesn't do the job, they'll eventually be forced to go higher.

Bill Dudley is a Bloomberg Opinion columnist and senior adviser to Bloomberg Economics. A senior research scholar at Princeton University, he served as president of the Federal Reserve Bank of New York and as vice chairman of the Federal Open Market Committee.