Today, we publish an article by David Paper and Luxandra ProdanProfessor of Economics and Teaching Associate Professor at the University of Houston.
The Federal Open Market Committee (FOMC) raised the target range for the federal funds rate (FFR) by 25 basis points to between 5.25% and 5.5% at its July 2023 meeting. Prior to this, rates had risen by a total of 5.0 percentage points between March 2022 and June 2023, after which they remained at the effective lower bound (ELB) for two years. The FOMC did not provide any guidance on the future path of FFR beyond the June 2023 Summary of Economic Projections (SEP).
The Fed is widely believed to be “behind the curve” by not raising rates in 2021 when inflation rises, forcing it to “catch up” in 2022. However, without measuring “on the curve.” In the latest version of our paper, “Policy rules and forward guidance in the wake of the Covid-19 recession’, we use data from the September 2020 to June 2023 SEP to compare policy rule mandates with actual and FOMC forecasts for FFR. Differences between projected FFRs.In our article we analyze four policy rules that are relevant to the future path of FFRs:
this Taylor (1993) The rules for the unemployment gap are as follows,
Where rightt is the rule-specified level of the short-term federal funds rate, PIt is the inflation rate, PILR is the 2% inflation target level, uLRt is the long-term unemployment rate of 4%. ut is the current unemployment rate, and rLRt is the neutral effective rate of 0.5% of the current SEP.
Yellen (2012) The balance law rule is analyzed, where the inflation gap coefficient is 0.5, but the unemployment gap coefficient is raised to 2.0.
After the Great Recession, the Balancing Act rule gained widespread attention and became the standard policy rule used by the Federal Reserve.
These rules are non-inertial because the FFR is fully adjusted whenever the target FFR changes. This is inconsistent with the FOMC’s approach of raising interest rates steadily when inflation rises.We specify an inertial version of the rule based on Clarida, Gary and Gertler (1999),
where is the degree of inertia and is the target level of the federal funds rate specified by equations (1) and (2).we set to Bernanke, Kelly and Roberts (2019). rightt-1 Equals the ratio prescribed by the rule if positive, or zero if the prescribed ratio is negative.
Figure 1 depicts the midpoint of the September 2020-June 2023 FFR target range and the September 2023-December 2025 FFR forecast based on the June 2023 SEP.
After exiting the ELB to 0.375 in March 2022, FFR rose to 5.375 in July 2023 and is expected to rise to 5.625 in December 2023 before declining in 2024 and 2025. The diagram also depicts policy rule provisions. For the September 2020-June 2023 period, we use real-time inflation and unemployment data provided at FOMC meetings. For the period September 2023 to December 2025, we use the June 2023 SEP’s inflation and unemployment forecasts. The difference between the FFR specified between inertial rules and non-inertial rules is much larger than the difference between Taylor rules and balancing method rules.
Panel A reports policy rule provisions for non-inertial Taylor and balanced approach rules. They are inconsistent with the FOMC’s practice of smoothing rate hikes as inflation rises. Through March 2021, the ELB’s regulations for both rules are the same. The FOMC has been behind the curve since June 2021, when the mandated FFR increased from 0.125 to 2.125 for the ELB’s Taylor rule and 0.375 for the Balanced Approach rule, while the actual FFR remained at the ELB middle. Policy rule rules increase sharply in 2021 and peak in March 2022 at 7.875 for Taylor rules and 8.125 for balance law rules, when FFR first rises above ELB above 0.375. The gap also peaks in March 2022 at 750 basis points for the Taylor rule and 775 basis points for the balanced law rule. Between March 2022 and June 2023, the gap narrows substantially, with FFR increasing from 0.375 to 5.125, while FFR under the Taylor rule falls by 75 basis points and FFR under the balancing act rule decreases by 50 basis points. Going forward, the gap between the FFR forecast and the policy rule mandate will narrow significantly in September 2023, and from December 2023 to December 2025, the FFR forecast will be higher than the policy rule mandate.
Panel B reports results for inertial Taylor and equilibrium method rules. They are more in line with the FOMC’s approach of slowly raising the FFR as inflation rises. Through March 2021, the provisions of these two rules are the same for the ELB, while the provisions of the Taylor rule rise to 0.375 in June 2021. The Federal Open Market Committee (FOMC) is behind the curve starting in September 2021, when the Taylor-rule mandated FFR increases to 0.875 and the Taylor-rule mandated FFR increases to 0.625. The balancing method rules, while the actual FFR remains in the ELB. The gap between policy rule provisions peaks in March 2022, with a difference of 200 basis points between the two rules. At this point, the stated FFR is 2.375, and the FFR first rises above the ELB to 0.375.
The Fed is no longer behind the curve. The gap has steadily narrowed, and in June 2023, FFR is equal to two policy rule provisions. The inertia rule dictates a much smoother path of rate hikes from September 2021 to June 2023 than the one adopted by the FOMC. Had the Fed followed the inertial Taylor or balancing act rules, rather than the FOMC’s forward guidance, it could have avoided the lagging curve, pivot, and back-on-track pattern that characterizes Fed policy in 2021 and 2022. By 2025, FFR forecasts are typically 25 basis points above policy rule mandates, with a range of 0 to 50 basis points. Current and projected FFRs are in line with inertial policy rules.
The author of this article is David Paper and Luxandra Prodan.
