The Federal Open Market Committee (FOMC or Committee) raised the target range for the federal funds rate (FFR) by 3/4 percent (75 basis points) from 2.25 – 2.5 percent to 3.0 – 3.25 percent at last week’s meeting and projected a range between 4.25 and 4.5 percent by the end of 2022. Following two years at the effective lower bound (ELB) of 0.0 – 0.25 percent and a liftoff of 25 basis points in its March 2022 meeting, the Committee has now implemented one 50 and three 75 basis point rate increases.
There is widespread agreement that the Fed fell “behind the curve” by not raising rates when inflation rose in 2021, forcing it to play “catch-up” in 2022 with headline-grabbing rate increases and market gyrations. Why did this occur? The “we didn’t know” explanation is that the Fed did not predict that inflation would rise so much in 2021 and, if they had, they would have raised rates earlier. The “they should have known” explanation is that the Fed should have known that inflation would not be transitory and raised rates sooner.
Most of the discussion of the Fed being behind the curve depends on subjective analysis of when liftoff from the ELB should have occurred. We propose a different explanation. If the Fed had followed its own policy rule, it would have started to raise rates in 2021:Q3 instead of 2022:Q1. With about twice as many meetings to implement the same total rate increase, each individual rate increase would have only needed to be about half as large. Since the policy rule uses inflation and unemployment data rather than forecasts, it makes the “we didn’t know” explanation irrelevant and the “they should have known” explanation unnecessary.
In an earlier paper, “Policy Rules and Forward Guidance Following the Covid-19 Recession,” and Econbrowser post, “The Fed Fell Behind the Curve by Not Following its Own Policy Rules,” we use data from the Summary of Economic Projections (SEP) from September 2020 to June 2022 to compare policy rule prescriptions with actual and FOMC projections of the FFR. This provides a precise definition of “behind the curve” as the difference between the FFR prescribed by the policy rule and the actual FFR.
The Taylor (1993) 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 2 percent target level of inflation, is the 4 percent rate of unemployment in the longer run, is the current unemployment rate, and is the ½ percent neutral real interest rate from the current SEP. We use real-time inflation and unemployment data that was available at the time of the FOMC meetings.
Yellen (2012) analyzed the balanced approach rule where the coefficient on the inflation gap is 0.5 but the coefficient on the unemployment gap is raised to 2.0.
The balanced approach rule received considerable attention following the Great Recession and became the standard policy rule used by the Fed.
The FOMC adopted a far-reaching Revised Statement on Longer-Run Goals and Monetary Policy Strategy in August 2020. The framework contains two major changes from the original 2012 statement. First, policy decisions will attempt to mitigate shortfalls, rather than deviations, of employment from its maximum level. Second, the FOMC will implement Flexible Average Inflation Targeting (FAIT) where, “following periods when inflation has been running persistently below 2 percent, appropriate monetary policy will likely aim to achieve inflation moderately above 2 percent for some time.”
We analyze Fed policy by using an inertial version of the balanced approach (shortfalls) rule introduced in the February 2021 Monetary Policy Report (MPR) in response to the Revised Statement. The rule mitigates employment shortfalls instead of deviations by having the FFR only respond to unemployment if it exceeds longer-run unemployment,
If unemployment exceeds longer-run unemployment, the FFR prescriptions are the same as with the balanced approach rule. If unemployment is below longer-run unemployment, the FOMC will not raise the FFR solely because of low unemployment.
While most of the attention following the Revised Statement focused on FAIT, the large rise in inflation in 2021 and 2022 has made that part irrelevant. With unemployment below 4.0 percent, however, mitigating shortfalls rather than deviations of employment remains an important aspect of policy.
These rules are non-inertial because the FFR fully adjusts whenever the target FFR changes. This is not in accord with FOMC practice to smooth rate increases when inflation rises. We also specify an inertial version of the balanced approach (shortfalls) rule 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 Equation (3). We set as in Bernanke, Kiley, and Roberts (2019). equals the rate prescribed by the rule if it is positive and zero if the prescribed rate is negative.
At its September 2020 meeting, the Committee approved outcome-based forward guidance, saying that it expected to maintain the target range of the FFR at the ELB “until labor market conditions have reached levels consistent with the Committee’s assessment of maximum employment and inflation has risen to 2 percent and is on track to moderately exceed 2 percent for some time.” The key word is “and”. While the Fed’s inflation goals were met by December 2021, liftoff from the ELB did not occur until its maximum employment goals were met in March 2022.
If the Fed had followed a policy rule using inflation and unemployment data from the FOMC’s quarterly SEP’s instead of the FOMC’s forward guidance, they could have avoided the pattern of falling behind the curve, pivot, and getting back on track that characterized Fed policy during 2021 and 2022. The rules prescribe liftoff from the ELB in 2021:Q2 or 2021:Q3 and a much smoother path of rate increases through the end of 2022 than that adopted/projected by the FOMC.
Figure 1 depicts the actual FFR for September 2020 to September 2022 and the projected FFR for December 2022 to December 2024 from the September 2022 SEP. Following the exit from the ELB to 0.375 in March 2022, the FFR rose to 1.625 in June 2022 and 3.125 in September 2022 and is projected to rise further to 4.375 in December 2022 and 4.625 in March 2023 before starting to fall in June 2024.
Figure 1: Balanced Approach (shortfalls) Rule: Non-Inertial and Inertial
The prescribed FFR with the non-inertial balance approach (shortfalls) rule is also illustrated in the figure. The prescribed exit from the ELB is in 2021:Q2, three quarters before the actual exit. Following liftoff from the ELB to 0.875 in 2021:Q2, the prescribed FFR sharply increases to 7.375 in 2022:Q1 before starting to fall in 2022:Q2. These prescribed rate increases are a completely unrealistic guide to policy as the prescribed FFR rises by over 100 basis points per meeting for the six meetings between June 2021 and March 2022.
Figure 1 also shows the prescribed FFR with the inertial balance approach (shortfalls) rule. The prescribed exit from the ELB is in 2021:Q3, one quarter after the prescribed exit with the non-inertial rule and two quarters before the actual exit. Following liftoff from the ELB to 0.375 in 2021:Q3, the prescribed FFR slowly increases to 3.375 in 2022:Q3, only 25 basis points above the actual FFR.
The Fed’s pivot can be seen by comparing the prescriptions from the balanced approach (shortfalls) rule with the FFR through September 2022 and the projected FFR thereafter. At the time of liftoff from the ELB in March 2022, the FFR was 175 basis points above the prescribed FFR. With the subsequent series of rate increases, the FFR is now only 25 basis points above the prescribed FFR. Starting in December 2022, however, the projected FFR rises to 50 basis points above the prescribed FFR and, with occasional exceptions, remains 50 basis points above the prescribed FFR through June 2025.
Policy rules provide a framework for monetary policy evaluation. Using the rule most in accord with the Fed’s objectives, the inertial balanced approach (shortfalls) rule, the Fed fell behind the curve in September 2021 and has just gotten back on track. Instead of staying on track, the Fed now projects that the FFR will be above the policy rule prescriptions for the next three years. Has the Fed pivoted too far by completely switching focus from unemployment to inflation? While it is obviously far too early to answer that question, following its own policy rule starting in 2021 would have enabled the Fed to balance both parts of its dual mandate and provided predictability for its future actions.
This post written by David Papell and Ruxandra Prodan.