Just how far behind the curve is the Fed in tackling inflation? In a word, very. It is time for decisive, but well-thought-out, monetary policy tightening.
Inflation can no longer be fully explained by base effects or temporary supply chain disruptions. The surge in US inflation is neither temporary nor transitory. Therefore, the time to end asset purchases and raise the policy rate is now. The only remaining questions are to what level and how fast the policy rate should be raised, and how speedily asset purchases should be tapered and ultimately reversed.
In what follows, I address these questions. Readers should be aware that this article contains some technical aspects which I feel are useful to help explain the Fed’s decision-making and the importance of the challenges it now faces.
Let’s begin with so-called ‘quantitative easing’. As it recently announced, the Fed will cut its net monthly asset purchases by $30 billion per month beginning in January 2022. It will therefore end its purchases by March 2022. Yet its fed funds target range, which has been 0.00% to 0.25% since March 2020, will remain for now unchanged. For reasons unknown, the Fed does not contemplate policy rate hikes until net asset purchases are zero.
That is a mistake, in my view. To explain why, let’s begin with a bit of theory, which helps us understand how central banks set policy rates.
A useful tool for evaluating the appropriate Federal funds rate consistent with the Fed’s dual mandate of stable prices and maximum employment is a modified version of the so-called Taylor rule, created in 1993 by Stanford economist John B. Taylor. The static version of the Taylor rule is given by:
where i is the nominal policy rate, rN is the short neutral real rate of interest, π is the actual rate of inflation, πˆ is the target rate of inflation and gap is the percentage difference between actual real GDP and potential real GDP – what GDP would be with full utilization of labor and capital.
The responsiveness of the policy rate to the deviation of actual inflation from the target inflation rate is measured by the coefficient α , which I set at 1.5, consistent with the original Taylor rule. The responsiveness of the policy rate to the output gap is measured by the coefficient β , which I will take to equal 1.0, higher than the 0.5 used in Taylor’s original formulation.
It is important that the value of α be greater than 1, because higher inflation ought to trigger an increase in the real interest rate to dampen economic activity and slow inflation.
The Taylor rule says that when inflation is at its target level and the output gap is closed, the nominal policy rate equals the neutral real rate of interest plus the target rate of inflation. The neutral real interest rate is the risk-free real interest rate that would prevail with the economy operating at full capacity, real GDP growing at the same rate as potential output, and inflation at its target level.
That said, there is no consensus on the neutral real rate. Underlying productivity growth and labor supply growth are, however, widely recognized as key determinants of the neutral real rate. So are planned business investment (positive for the neutral real rate) and planned saving (negative for the neutral real rate). In the original Taylor rule paper, Taylor assumed a value of 2% for the U.S. neutral real interest rate. Subsequent academic estimates for the two decades leading up to the global financial crisis (GFC) ranged mostly between 2-3%, though after the GFC estimates have fallen sharply, with most between 0-1%.
I will assume a neutral real policy rate of 0.5%. With a target rate of inflation of 2%, it follows that the ‘neutral’ (or equilibrium) nominal federal funds rate is 2.5%, far above its current target range near 0%.
How large is the output gap today? Just prior to the pandemic, the economy was operating at capacity. Following a short but sharp fall in output in 2020 as the pandemic arrived, the economy has bounced back vigorously. Real GDP growth was 6.7% in the second quarter of 2021 and 2.3% in the third quarter. The median projection of the FOMC for GDP growth in 2021 is 5.5% and 4.0% for 2022. If those projections are correct, US GDP will have crossed its pre-Covid trend forecast towards the end of 2021.
Indeed, I believe that the US output gap turned positive no later than the third quarter of 2021. De-globalization, the political and business sector responses to climate change, and Covid-19 have had a lasting negative impact on potential output and employment. Potential output is depressed by the move from just-in-time to just-in-case corporate management of supply chains and by other resilience-enhancing changes in business strategy. Significant early retirements and increased job mismatches as evidenced by a record-high number of unfilled vacancies (over 11 million job openings in October 2021), compounded by lower immigration are likely to be enduring features of the US economy.
Accordingly, an unemployment rate of 4.2% is probably below the natural rate of unemployment, even though it exceeds its level just prior to the Covid-19 pandemic. Equally, the drop in the labor force participation rate, at 61.8% in November 2021, is a structural, not a cyclical, phenomenon. Inflationary pressures in the labor market are rising, despite non-farm employment remaining 3.9 million below its February 2020 level, as evidenced by the record high quit rates (3.1 million in October 2021) and rising wage inflation (wage and salary disbursements rose 8.9% yoy in November 2021).
Returning to the modified Taylor Rule, my best guess is that by the end of 2021, actual GDP was 1% larger than potential GDP. With β = 1 in my preferred specification of the Taylor rule, this implies a further increase in the target policy rate by a full percentage point.
Turning to inflation, I would first argue that current or expected inflation is most appropriate for determining the proper policy response. As a reminder, core personal consumption expenditures inflation (the Fed’s preferred metric) is presently 4.6%. But in the Fed’s forecasts, a miracle happens. Despite projections of negative inflation-adjusted policy rates over the next three years and above-trend growth, core PCE inflation gradually and implausibly slows in 2022-2024 to 2.7%, 2.3% and 2.1%.
In the Fed’s forecasts, the economy experiences immaculate disinflation.
Everything is possible, but not everything is likely. Instead, I would set expected inflation in the Taylor rule equal to 4.0%. With the coefficient (‘alpha’) equal to 1.5, the “inflation response” in the Taylor rule adds another three percentage points to the required policy rate. When toting up the inflation, output gap and neutral rate estimates, the appropriate rule-based target for the Fed funds rate ends up at 6.5%!
Even worse, that target rate could well be higher. The 0.5% figure for the neutral real interest rate is probably on the low side. The 4.0% inflation rate is below the current core PCE inflation rate, which averaged 4.5% in the first three quarters of 2021.
It is also worth asking, could the target rate be lower? It would be if the output gap assumption were one of balance today, which is implausible in my view. Still, that would only lower the target policy rate to 5.5%. Even if the output gap were negative by 1%, the appropriate policy rate would still be 4.5%. If one were to take the Fed’s own optimistic disinflation forecasts for the next two years as the inflation input—a heroic underestimation in my view—the target policy rate would still be 2.25%, well above today’s ‘zero rate’.
In short, no matter how you slice it, the Fed is far behind the curve when it comes to achieving its dual mandate. So, how fast and how far should the Fed now move?
First, the time to start is now. There is no justification for waiting until asset purchases have ended. Indeed, insofar as asset purchases shore up financial stability, rate hikes ought to precede the end of ‘quantitative easing’.
Will the Fed follow the Taylor rule prescription? I doubt it. And a valid reason for not blindly following the Taylor rule is financial stability, which the Taylor Rule does not take into consideration.
Financial stability is the primary mandate of any central bank. It takes precedence over both price stability and maximum employment because it is a precondition for both. A big step towards the pursuit of price stability, along the lines warranted by the Taylor rule—such as hiking the policy rate immediately to the neutral level of 2.5%—would create financial havoc at home and abroad.
Households, financial and non-financial corporations, and governments have taken on massive debts and are exposed to financial stress via an array of derivatives. Debt and other risky financial obligations have been assumed in the expectation that interest rates would remain at extremely low levels for years to come. One might wish to argue caveat emptor, but the exposures are simply too large to apply that logic.
Moreover, past central bank rhetoric and forward guidance, in the U.S. and elsewhere, helped shape the low interest rate expectations that drove the excessive borrowing and other risky financial commitments. If central banks were to simply abrogate what the financial markets took to be prior statements of commitment, massive capital losses and debt servicing problems could trigger systemically risky defaults. The repercussions and turmoil would be global, with emerging markets and developing countries among the worst afflicted. The central banks’ credibility would be shattered.
So, contrary to the prescriptions of a Taylor Rule, caution and care are required. The Fed must also always be prepared to use its balance sheet to intervene as lender of last resort and market maker of last resort, domestically and, because of the unique global role of the US dollar, also internationally.
In addition, uncertainty also prevails as regards the pandemic and the outlook for US fiscal policy. Those uncertainties alongside the risks to financial stability warrant monetary policy caution. Discretion trumps rules under these circumstances. Yet caution does not mean that the Fed must postpone its first policy rate hike until March 2022, or that the policy rate can only be raised in increments of 0.25% at each regularly scheduled FOMC meeting. With inflation overshooting the target and the output gap neutral or positive, caution dictates moving interest rates expeditiously above the neutral rate, for instance in two well-communicated steps of 1.25% each.
The Fed and other leading central banks are at risk of losing their credibility as guarantors of price stability if they do not now respond to inflation. That credibility was achieved during the 1980s at considerable cost in terms of forgone output and employment. We should not have to pay that bill again. Ensuring that inflation remains in check under current circumstances requires monetary policy discretion, a willingness to ‘bend’ rules, but not break them. With proper communication, that can be done without spooking the markets or impairing the workings of the financial system.
The Fed faces a challenging, but not impossible, task. It should not, however, dither. The time for action is now.
