Today, we present an article by David Paper and Russandra ProdinProfessor 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 a range of 4.5% to 4.75% at its January/February 2023 meeting, and expected continued increases to be appropriate. Subsequently, between March 2022 and December 2022, rates have increased by a total of 4.25 percentage points, with the effective lower bound (ELB) for the following two years.
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 compare policy rule mandates with FFR’s actual and FOMC forecasts, using data from the September 2020-December 2022 Summary of Economic Projections (SEP). This provides a precise definition of “behind the curve,” namely The difference between the FFR specified by the policy rule and the actual or projected FFR.We analyze four policy rules:
this Taylor (1993) The rules for the unemployment gap are as follows,
where is the rule-regulated short-term federal funds rate level, is the inflation rate, is the 2% target inflation level, is the long-run unemployment rate of 4%, is the current unemployment rate, and is the ½% neutral real rate of the current SEP.
Yellen (2012) The balanced approach rule is analyzed, where the coefficient for the inflation gap is 0.5, but the coefficient for the unemployment gap is raised to 2.0.
The balanced approach rule received considerable attention after the Great Recession and became a standard policy rule used by the Federal Reserve.
The FOMC took a far-reaching Modification statement On long-term goals and monetary policy strategy for August 2020. This framework contains two significant changes from the original 2012 statement.First, policy decisions will attempt to mitigate Inadequaciesinstead of deviation, from its highest level of employment. Second, the FOMC will implement Flexible Average Inflation Targeting (FAIT), “after a period of sustained inflation below 2 percent, appropriate monetary policy is likely to achieve the inflation objective moderately above 2 percent for some time.”
While most of the attention following the revised statement has been on FAIT, the sharp rise in inflation in 2021 and 2022 renders this part irrelevant.Balanced approach (deficiency) rules introduced in February 2021 monetary policy report (MPR). This rule mitigates employment shortages rather than biases by having the FFR respond to the unemployment rate only when it exceeds the long-term unemployment rate,
If the unemployment rate exceeds the long-term unemployment rate, the FFR prescription is the same as the balancing method rule. If the unemployment rate is lower than the long-term unemployment rate, the FOMC will not raise the FFR just because of low unemployment. We also analyzed the Taylor (shortage) rule,
These rules are non-inertial because the FFR is fully adjusted whenever the target FFR changes. That’s at odds with the FOMC’s approach of steadily raising rates as inflation rises. During 2021 and 2022, the non-inertial rules dictate an unrealistically large increase in FFR.
We specify the rule-based inertial version Clarida, Gary and Gertler (1999),
where is the degree of inertia and is the target level of the federal funds rate specified by equation (3).we set to Bernanke, Keeley and Roberts (2019). Equal to the rate specified by the rule if positive, or zero if the specified rate is negative.
The graph plots the midpoint of the September 2020-December 2022 FFR target range and projected FFR from the December 2022 SEP to March 2023-December 2025. After exiting the ELB to 0.375 in March 2022, FFR rose to 4.625 in February 2023 and is expected to rise to 5.125 in June 2023 before declining in 2024 and 2025.
Figure 1, panel A: The Inertial Policy Rule and the Federal Funds Rate – The Taylor Rule
Group A of the Taylor rule and Group B of the balanced approach rule report policy rule provisions. For September 2020 to December 2022, we use real-time inflation and unemployment data available during FOMC meetings. From March 2023 to December 2025, we use inflation, unemployment, and real FFR in our December 2022 SEP long-run forecast.
Figure 1, panel B: Inertial Policy Rules and the Federal Funds Rate—Balanced Approach Rules.
FFR falls “behind the curve” when the prescribed FFR increases above the ELB in June 2021 for the Taylor rule and September 2021 for the balanced approach rule. At the launch of the ELB in March 2022, the Taylor Rule gap reaches 200 basis points and the Equilibrium Rule gap reaches 175 basis points. With the FOMC aggressively raising FFR, the gap narrowed in September to 25 basis points above FFR’s balanced approach (shortage) rule for 2022, with the other three rules’ FFRs 50 basis points above.
We emphasize two points shown in Figure 1. First, as described in more detail in this paper, the FOMC could have achieved the same FFR increase through September 2022 without resorting to a 75 basis point hike by following any policy rules. Second, balanced approach rule prescriptions are closer to the path of FFR than Taylor rule prescriptions.
The relationship between actual FFR and stated FFR reverses in December 2022, as FFR is 50 basis points above FFR prescribed by the Balancing Act (shortage) rule, while the other three rules are 25 basis points above FFR. For 2023 to 2025, the graph shows the FFR for the December 2022 SEP forecast and the FFR mandated by the policy rule using the December 2022 SEP forecast data. The gap widens by December 2023, then narrows as FFR forecasts fall.
The relationship between the Taylor Rule and the Balanced Approach Rule regulation also reverses with the December 2025 SEP, as the gap between the Taylor Rule FFR forecast and the Policy Rule regulation is smaller than the Balanced Approach Rule. Starting March 2024, the Taylor rule gap narrows to 25 basis points, and the Taylor rule prescription equals the FFR forecast for the June-December 2025 period.
This article was sponsored by David Paper and Russandra Prodin.
