Opinion: Fed should raise rates to 5% to quench overheating economy, according to Taylor rule

STANFORD, Calif. (Project union) —In recent months, a growing number of economic observers have expressed concern about rising inflation in the United States.

Much of the commentary (including my own) focused on the apparent continuation of the Federal Reserve’s accommodative monetary policy in the face of rising prices. Despite a sharp acceleration in the rate of money growth, the central bank is still engaged in a large-scale asset purchase program (to the tune of $ 120 billion per month), and kept the federal funds rate within a range of 0.05-0.1%.

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This rate is exceptionally low compared to similar periods in recent history. To understand why this is exceptional, there is no need to look any further than that of the Fed on July 9, 2021, Monetary Policy Report, which includes long-studied policy rules that would prescribe a policy rate higher than the current real rate. One is the “Taylor rule,” whereby the Fed should set its target federal funds rate based on the gap between actual and target inflation.

Taylor rule calculations

The Taylor rule, expressed as a simple equation, has worked well when followed over the years. If you plug in the current inflation rate over the past four quarters (about 4%), the gap between gross domestic product and its potential for the second quarter of 2021 (about -2%), a target inflation rate of 2%, and a so-called equilibrium interest rate of 1%, you get a desired federal funds rate of 5%.

Moreover, Taylor’s rule implies that even if the inflation rate drops to 2% by the end of this year (which would be well below most forecasts) and economic output reaches its potential, the federal funds rate should always be 3%. That’s a far cry from the near zero level implied by the Fed’s forecast.

Since these calculations use the average inflation rate for the last four quarters, they are consistent with a form of “targeting average inflation”That the Fed itself endorsed last summer. They also follow the Fed’s recently suggested breakeven interest rate of 1%, rather than the 2% rate that has been traditionally used. If the latter had been used, the difference between the policy rate of the rule and the actual level of the fund rate would be even greater.

These possible higher levels for the federal funds rate are largely ignored in the discussions reported by the Fed. Instead, the Fed insists that today’s higher inflation is a temporary byproduct of the pandemic’s effect on inflation last year.

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Are the markets leading or following the Fed?

Those who defend its current position point out that market interest rates on longer-term bonds remain very low. At safe treasury assets, the five-year yield TMUBMUSD05Y,
0.838%
is only 0.81%, and the 10-year yield TMUBMUSD10Y,
1.332%
is only 1.35%, well below the rates suggested by the Taylor rule when averaged over these maturities. Considering these factors, many commentators say they don’t worry: markets are probably rational when forecasting low rates.

The problem with this reasoning is that the low long-term rates are likely due to the Fed’s insistence on keeping rates low as far as the eye can see. As Josephine M. Smith and I show in a 2009 study, there is a “structure of the terms of the police rules” to be taken into account. This is because the policy rule for longer-dated bonds depends on the policy rule for the shorter-term fed funds rate FF00,
-0.01%,
as perceived by people in the market. If the Fed convinces the market that it will stay low, the term structure of interest rates will mean lower long-term rates.

Enigma

The situation today is similar to that of 2004, when then Fed Chairman Alan Greenspan noticed that 10-year Treasury yields did not appear to be tied to movements in the fed funds rate. He called it a “enigmaBecause the real short-term interest rate did not generate as large an increase in long-term interest rates as might be expected based on previous experience. Tightening monetary policy has not had as much of an effect on long-term rates as in previous periods of tightening.

During that time, the fed funds rate deviated significantly from what would have been predicted by the typical Fed response, just as it is doing today. When the real federal funds rate deviated significantly from the level suggested by policy rules, the response of short-term interest rates to inflation appeared to be much weaker, at least from the perspective of market participants. trying to assess Fed policy. And this perception of a lower response coefficient in the policy rule may have led market participants to expect weaker responses from long-term interest rates to inflation, and hence to rates of interest. lower long-term interest.

Today, it appears that the Fed is deviating from monetary policy rules. It has beaten its own path when it comes to forward guidance and the market is basing its estimates of future rates on the expectation that this spread will continue.

But history tells us that it cannot continue indefinitely. Eventually, the Fed will have to revert to a policy rule, and when it does, the conundrum will disappear. The sooner this happens, the smoother the recovery will be. There is still time to adapt and come back to a political rule, but time is running out.

John B. Taylor, former Under-Secretary of the Treasury (2001-05), is Professor of Economics at Stanford University and Senior Fellow at the Hoover Institution. He is the author of “Global Financial Warriors” and co-author (with George P. Shultz) of “Choose Economic Freedom”.

This comment was posted with permission from Project union – The Fed’s state of emergency