Today we publish an article by David Papel and Ruksandra Prodan-BullProfessor of Economics at the University of Houston and Lecturer in Economics at Stanford University.
The Federal Open Market Committee (FOMC) maintained the target range for the federal funds rate (FFR) at 5.25% – 5.5% at the March 2024 meeting Economic Forecast Summary (SEP) continues to forecast that by the end of 2024, the FFR will range between 4.5% and 4.75%. The futures market summary compared to experience through December 2023 is as follows: CME Group Fed Watch Tool Rates on the second day of the meeting were in line with the FOMC's forecasts, predicting that FFR would range between 4.5% and 4.75% by the end of 2024.
The Fed is widely seen as “behind the curve” by not raising interest rates in 2021 when inflation rose, forcing it to “catch up” in 2022. However, without measuring “on the curve.” In our paper, “Policy rules and forward guidance following the Covid-19 recession”, we compare policy rule provisions to actual and FOMC forecasts of FFR using SEP data from September 2020 to December 2023. This provides a precise definition of “behind the curve,” that is, policy rule provision of FFR versus actual or The difference between expected FFR. In this article, we analyze four policy rules related to the future path of the FFR, update the policy rule provisions before the March 2024 SEP, and include futures market forecasts.
this Taylor(1993) The rules for unemployment gap are as follows,
where is the short-term federal funds rate level specified by the rules, is the inflation rate, is the 2% inflation target level, is the long-term unemployment rate of 4%, is the current unemployment rate, and is the current SEP neutral real interest rate of 0.5%.
Yellen (2012) The balancing law rule is analyzed, in which the inflation gap coefficient is 0.5, but the unemployment gap coefficient is increased to 2.0.
After the Great Recession, the balancing act received widespread attention and became a standard policy rule used by the Federal Reserve.
These rules are non-inertial in that whenever the target FFR changes, the FFR will adjust completely. This is inconsistent with the FOMC's approach of steadily raising interest rates when inflation rises.We specify the inertial version of the rule based on Clarida, Galli and Gertler (1999),
where is the degree of inertia and is the target level of the federal funds rate specified in equations (1) and (2).We set it to Bernanke, Kelly and Roberts (2019). If positive, it is equal to the ratio specified by the rule; if the specified ratio is negative, it is equal to zero.
Figure 1 depicts the midpoint of the September 2020 to March 2024 FFR target range and the June 2024 to December 2026 FFR forecast based on the March 2024 SEP. Figure 1 also depicts the policy rule provisions. We use immediate inflation and unemployment data available at FOMC meetings between September 2020 and March 2024. For the period June 2024 to December 2026, we use inflation and unemployment forecasts from the March 2024 SEP. The difference between the prescribed FFRs between inertial and non-inertial rules is much greater than the difference between the Taylor rule and the balanced approach rule.
figure 1: Federal funds rate and policy rule provisions. Top panel: non-inertial rules; Bottom panel: The rule of inertia.
Panel A reports policy rule prescriptions for non-inertial Taylor and equilibrium approach rules. They are well above the FFR in 2022 and 2023 and are inconsistent with the FOMC's approach to smooth rate increases when inflation rises. In comparison, the policy rule provisions for 2024 to 2026 in the March 2024 SEP are consistently lower than the FFR forecast. Group B's inertia rule dictates a much smoother rate hike path from September 2021 to September 2023 than the one adopted by the FOMC. Had the Fed followed inertial Taylor or balancing rules rather than the FOMC's forward guidance, it could have avoided the backward curve, turnaround, and back-on-track pattern that characterized Fed policy in 2021 and 2022. The March 2024 SEP FFR forecast is very close to the policy rule provisions through December 2026. Current and projected FFR are consistent with the provisions of the inertia policy rules.
It has been widely reported that market participants are predicting a steeper downward path for the FFR than for the FOMC. This is illustrated in Figure 2, which plots futures market forecasts for the period from February 1, 2024 (the day after the January 2024 FOMC meeting) through the end of the CME forecast horizon in December 2024, as depicted in the CME FedWatch tool median. From June 2024 to December 2024, market forecasts will be lower than the projected FFR.This is described in more detail in our February 9, 2024 Econbrowser postal.
figure 2: FFR, CME FedWatch Tools and Policy Rules for December 2023. Top panel: Taylor Rule; base plate: A balanced approach.
The futures market no longer predicts a steeper decline in FFR than the FFR forecast. Figure 3 plots the median futures market forecasts depicted in the CME FedWatch tool from March 21, 2024, the day after the March 2024 FOMC meeting, through the end of the CME forecast horizon in September 2025. The market is fully consistent with the FOMC as futures market forecasts are identical to FFR forecasts. The change from December 2023 to March 2024 is entirely due to changes in CME forecasts, as the FFR forecast through December 2024 remains unchanged. The market has caught up with the Fed, not the other way around.
We supplement this discussion by including provisions in policy rules. Figure 3 shows that for the Taylor Law rule and the Balancing Law rule, the prescription of the inertia policy rule from March 2024 to December 2025 is close to the (identical) FOMC forecast and CME forecast. In comparison, the provisions of both non-inertial policy rules were well below the Federal Open Market Committee (FOMC) forecast and the Chicago Mercantile Exchange (CME) forecast for the same period. The comparison between futures market forecasts and policy rule prescriptions depends on the choice between inertial and non-inertial rules, not on the choice between Taylor rules and equilibrium approach rules.
image 3: March 2024 FFR, CME FedWatch Tools and Policy Rules
Top panel: Taylor Rule; Bottom panel: A balanced approach.
The author of this article is David Papel and Ruksandra Prodan-Bull.
