Today, we present a guest post written by David Papell and Ruxandra Prodan-Boul, Professor of Economics at the University of Houston and Lecturer in Economics at Stanford University.
The Federal Open Market Committee (FOMC) kept the target range for the federal funds rate (FFR) at 5.25 – 5.5 percent at its June 2024 meeting and, in the Summary of Economic Forecasts (SEP), forecast a reduction of one percentage point in the FFR range between percent 5.0 and 5.25 by the end of 2024. Futures markets summarized the CME FedWatch tool after the meeting predicted two rate cuts with the FFR range between 4.75 – 5.0 percent by the end of 2024. Comparison with 2024 instructions. inertial policy rules when the FOMC rate is smoothed up when inflation rises to the forecast from the SEP, the FOMC went from “walking” in March to “high for a long time” in June.
There is widespread agreement that the Fed fell “behind the curve” by not raising rates when inflation picked up in 2021, forcing it to play “catch-up” in 2022. “Behind the curve,” however, means nothing more than a measure of “on the curve.” In our paper, “Policy Orders and Forward Guidance Following the Covid-19 Economic Downturn,” we use data from SEPs from September 2020 to December 2023 to compare policy orders to the FOMC’s actual FFR projections. This gives a precise definition of “behind the curve” as the difference between the FFR set by the policy rule and the actual or assumed FFR. In this post, we analyze the four policy rules relevant to the FFR’s future path, review the instructions for the policy rules until June 2024 SEP, and include future market projections.
Taylor’s (1993) law with the unemployment gap is as follows:
where is the statutory short-term federal funds rate, the inflation rate, the target inflation rate of 2 percent, the 4 percent long-term unemployment rate, the current unemployment rate, and is the real interest rate of ½ percent from – Current SEP.
Yellen (2012) analyzed the balanced employment rule where the coefficient of the inflation gap is 0.5 but the coefficient of the unemployment gap is increased to 2.0.
The balance sheet rule received a lot of attention following the Great Depression and became the standard policy rule used by the Fed.
These rules are not inertial because the FFR adjusts fully whenever the target FFR changes. This is inconsistent with the FOMC’s practice of accelerating rate hikes when inflation rises. We specify internal versions of the rules based on Clarida, Gali, and Gertler (1999),
where is the degree of inertia and is the target rate of the federal funds rate set by Equations (1) and (2). We set it as in Bernanke, Kiley, and Roberts (2019). is equal to the rate prescribed by the law if it is positive and zero if the prescribed rate is negative.
Figure 1 shows the midpoint of the FFR target range for September 2020 to June 2024 and the proposed FFR for September 2024 to December 2026 from the June 2024 SEP. Figure 1 also shows the instructions for the policy rules. Between September 2020 and June 2024, we use real-time inflation and unemployment data that were available during FOMC meetings. Between September 2024 and December 2026, we use inflation and unemployment projections from June 2024 SEP. The difference in the determined FFRs between the inertial and non-inertial laws is much greater than that between the Taylor and the balanced operating laws.
The instructions for the policy rules are reported in Panel A for the non-inertial Taylor and balanced path rules. They are significantly higher than the FFR in 2022 and 2023 and are inconsistent with the FOMC’s tendency to slide rate hikes when inflation rises. In contrast, the 2024 to 2026 policy orders from the June 2024 SEP remain lower than the FFR projections. The inertial rules in Panel B dictate a much easier rate hike path from September 2021 to September 2023 than the one adopted by the FOMC. If the Fed had followed the inactive Taylor rule or the balanced path rule instead of the FOMC’s forward guidance, it could have avoided the pattern of falling behind the curve, pivoting, and returning to the path that characterized Fed policy during 2021 and 2022.
Looking ahead, policy orders from the June 2024 SEP are below the projected FFR through September 2025 and closer to the projected FFR through December 2026. Although current and projected FFR are generally consistent with the inactive policy orders, the gaps are larger in 2024 than in March. SEP because the FOMC indicated a 3 percent rate cut in March and a 1/4 rate cut in June. The March 2024 SEP results for this and the next two sections are shown in our Econbrowser post.
Figure 2 shows the average forecast from the futures market defined in the CME FedWatch Tool following the June 2024 FOMC meeting until the end of the CME forecast horizon in September 2025. The futures market forecasts are ¼ percent below the FOMC forecast before the last meeting because time markets In the future they are predicting two rate cuts while the FOMC projects one rate cut in 2014. The pattern of lower futures market forecasts than the FOMC projections is consistent with December 2023 but not March 2024, when projections and projections were similar.
We add to this discussion by including instructions from the policy rules. Figure 2 shows that, for both the Taylor rule and the balance of operations, the instructions from the idle policy rules for June 2024 to December 2025 are generally below both the CME forecast and the FOMC forecast but are closer to the CME forecast than the FOMC. In addition, the gap between the instructions for the idle policy rules and the CME projections is widening between March and June of 2024. The instructions from both non-inertial policy rules are significantly below the FOMC forecast and the CME forecast for the same period. The comparison between future market forecasts and prescriptions for policy rules depends more on the choice between passive and informal rules than on the choice between Taylor and balanced approach rules.
This post was written by David Papell again Ruxandra Prodan-Boul.
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