By David Papell
The Federal Open Market Committee voted last Wednesday to keep the federal funds target rate at a record low of between zero and 0.25 percent. If it was not constrained by the zero lower bound, should the federal funds rate be negative? If the answer is yes, this suggests that the rate should remain at its record low for a considerable period and provides a justification for continued increases in the Fed’s balance sheet. If the answer is no, then the Fed may need to raise its interest rate target sooner rather than later.
There has been a lively debate on this topic in the context of the Taylor rule for monetary policy. The debate started with an article in the Financial Times, which cites a confidential Fed staff study that placed the implied Taylor rule rate at negative 5 percent. John Taylor, speaking at the Atlanta Fed, counters that the Fed got both the sign and the decimal point wrong and calculates the rate at 0.5 percent. Glenn Rudebusch, writing in the San Francisco Fed’s Economic Letter, argues for negative 5 percent. Most recently, Taylor writes in a Bloomberg.com commentary that the rate should be zero.
In its original form, the Taylor rule states that the Fed’s interest rate target should be one plus 1.5 times the inflation rate plus 0.5 times the output gap. According to the most recent Congressional Budget Office (CBO) projections, “core” CPI inflation, excluding food and energy, was 2.0 percent in 2008 but is expected to fall to 1.6 percent in 2009. The output gap is expected to be negative 7 percent in the second half of 2009 and the first half of 2010. Using 2.0 percent for inflation, the implied rate is 0.5 percent while, with 1.6 percent inflation, the rate is -0.1 percent, both around the Fed’s current target.
The implied interest rate target can change if the Taylor rule is modified. It is often argued that, because monetary policy is forward-looking, policy evaluation with Taylor rules should be conducted using forecasts rather than actual data. The CBO forecasts that core inflation will fall further to 1.1 percent in 2010. Using this forecast, the implied rate falls to -0.85 percent. More dramatically, Rudebusch and others argue that the coefficient on the output gap in the Taylor rule should be 1.0 instead of 0.5. With inflation forecasts and the larger output gap coefficient, the implied Taylor rule interest rate falls to -4.35 percent.
In “Taylor Rules and the Great Inflation: Lessons from the 1970s for the Road Ahead for the Fed,” written with Alex Nikolsko-Rzhevskyy of the University of Memphis, we use research on the natural rate of unemployment published in the 1970s to construct real-time output gap measures for the periods of peak unemployment in 1971 and 1975, and argue that real-time linear and quadratic detrended output gaps provide the best measure of what policymakers perceived the output gap to be at the time. Using these gaps to estimate Taylor rules, we conclude that:
- The Fed did not follow a stabilizing Taylor rule in the 1970s. In order for policy to be stabilizing, the federal funds rate needs to be raised more than point-for-point when inflation increases, so that the real interest rate rises. Our estimates never produce a coefficient on inflation that is significantly greater than one.
- The Fed did follow a stabilizing Taylor rule if inflation forecasts, rather than inflation rates, are used. These forecasts, however, systematically under-predicted inflation following the 1970s recessions and this does not constitute evidence of stabilizing policy.
- The Fed responded too strongly to negative output gaps, with estimated coefficients between 0.7 and 1.0.
In the 1970s, the Fed “stabilized” overly optimistic inflation forecasts and responded too strongly to output gaps, lowering interest rates too much — especially during and following the 1970-1971 and 1974-1975 recessions, resulting in frequent recessions and the Great Inflation. What are the lessons from the 1970s for Fed policy today?
- The Fed should respond to inflation, not inflation forecasts, especially in an environment where large negative output gaps are causing forecasted inflation to fall.
- The Fed should not tinker with Taylor’s output gap coefficient of 0.5.
Using the rule with Taylor’s original coefficients, the experience of the 1970s suggests that, even if it could, the Fed should not lower its interest rate target below zero. If the incipient recovery takes hold and inflation stays the same or rises, it may need to raise rates sooner than many people think.
This post written by David Papell.