Today we present to you a guest article written by David Papell And Ruxandra Prodan-Boulprofessor 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) between 5.25 and 5.5 percent at its June 2024 meeting and, at the Summary of economic projections (SEP), forecasts a quarter percent rate cut with a range for the FFR of between 5.0 and 5.25 percent by the end of 2024. Futures markets summarized by the CME FedWatch Tool After the meeting, he predicted two rate cuts with a range for the FFR between 4.75 and 5.0 percent by the end of 2024. Comparing the inertial policy rule prescriptions where the FOMC smooths rate increases when inflation rises to SEP projections, the FOMC went from “on track” in March to “higher for longer” in June.
It is widely believed that the Fed fell “behind the curve” by not raising rates when inflation rose in 2021, forcing it to catch up in 2022. “Behind the curve” is meaningless, however. without a measurement of “on the curve.” In our article, “Policy rules and forward guidance following the Covid-19 recession“, we use SEP data from September 2020 to December 2023 to compare policy rule prescriptions with actual and FOMC projections of the FFR. This provides a precise definition of the term “behind the curve” as the difference between the FFR prescribed by the policy rule and the actual or projected FFR. In this article, we analyze four policy rules relevant to the future development of the FFR, update the policy rule prescriptions to the June 2024 SEP, and include the futures market forecast.
THE Taylor (1993) The rule with an unemployment gap is as follows,
where is the level of the short-term federal funds interest rate prescribed by the rule, is the inflation rate, is the target inflation level of 2 percent, is the long-term unemployment rate of 4 percent term, is the current unemployment rate, and corresponds to the neutral real interest rate of ½ percent of the current SEP.
Yellen (2012) analyzed the balanced approach rule where the inflation gap coefficient is 0.5 but the unemployment gap coefficient is increased to 2.0.
The balanced approach rule received considerable attention after the Great Recession and became the standard policy rule used by the Fed.
These rules are not inertial because the FFR adjusts completely every time the target FFR changes. This is inconsistent with the FOMC’s practice of smoothing rate hikes when inflation rises. We specify inertial versions of the rules based on Clarida, Gali and Gertler (1999),
where is the degree of inertia and is the target level of the federal funds rate prescribed by equations (1) and (2). We put as in Bernanke, Kiley and Roberts (2019). is equal to the rate prescribed by the rule if it is positive and to zero if the prescribed rate is negative.
Figure 1 represents the midpoint of the target range of the FFR from September 2020 to June 2024 and the projected FFR from September 2024 to December 2026 from the SEP of June 2024. Figure 1 also illustrates the policy rule prescriptions. Between September 2020 and June 2024, we use real-time inflation and unemployment data available at the time of FOMC meetings. Between September 2024 and December 2026, we use the June 2024 SEP inflation and unemployment projections. The differences in prescribed FFRs between inertial and non-inertial rules are much larger than those between Taylor rules and balanced approach.
Policy rule prescriptions are shown in Panel A for the non-inertial Taylor and balanced approach rules. They are well above the FFR in 2022 and 2023 and are not consistent with the FOMC’s practice of smoothing rate hikes when inflation rises. On the other hand, the prescriptions of the political rules for 2024 to 2026 of the SEP of June 2024 are systematically lower than the FFR projections. The Part B inertia rules prescribe a much gentler rate hike path from September 2021 to September 2023 than that adopted by the FOMC. If the Fed had followed Taylor’s inertial rule or balanced approach instead of the FOMC’s forward guidance, it could have avoided the pattern of falling behind the curve, pivoting, and getting back on track that characterized the Fed policy in 2021 and 2022.
Looking ahead, the June 2024 SEP policy rule prescriptions are lower than the FFR projections through September 2025 and are close to the FFR projections through December 2026. Although the current and projected FFR are generally consistent with Prescriptions of inertial policy rules, the deviations are larger for 2024 than during the March SEP, as the FOMC forecast a rate cut of 3 ¼ percent in March and 1 ¼ percent in June. The results of the March 2024 SEP in this paragraph and the next two paragraphs are presented in our Econbrowser. job.
Figure 2 plots the median futures market forecasts outlined in the CME FedWatch tool from the June 2024 FOMC meeting through the end of the CME forecast horizon in September 2025. Futures market forecasts are ¼ percent lower than FOMC projections before converging at the end as futures markets forecast two rate cuts while the FOMC forecasts one rate cut in 2014. The trend of futures market forecasts lower than FOMC projections is consistent with December 2023 but not with March 2024, where the predictions and projections were identical.
We complete this discussion by including prescriptions from political rules. Figure 2 shows that, for both the Taylor rules and the balanced approach, the inertial policy rule prescriptions for June 2024 to December 2025 are generally lower than the CME predictions and the FOMC projections, but are closer to the CME predictions than FOMC projections. Furthermore, the gap between the prescriptions of the inertial policy rules and the CME forecasts widens between March and June 2024. The prescriptions of the two non-inertial policy rules are considerably lower than the FOMC projections and the CME forecasts for the same period. The comparison between futures market forecasts and policy rule prescriptions depends more on the choice between inertial and non-inertial rules than on the choice between Taylor’s rules and those of the balanced approach.
This article written by David Papell And Ruxandra Prodan-Boul.
