Interest rates are much lower than academic formulas suggest, Fed report says

Several simple mathematical formulas used to inform where to set interest rates under current economic conditions show that high inflation may require the Federal Reserve to set rates between 4% and 7% this year, according to a report from the central bank on Friday. .

The Fed consults with but does not follow these policy-making rules unconditionally when setting interest rates because they take into account a narrow set of economic data and do not take into account the central bank’s difficulty in stimulating growth during recessions when rates are close. zero.

Such formulas could add to perceptions that the Fed feels a greater need to raise interest rates more aggressively as it seeks to combat high inflation.

The Fed raised its benchmark interest rate by 0.75 percentage points this week to a range between 1.5% and 1.75%, a larger increase than the half-point rate hike that most officials said they expected two weeks ago. All 18 officials in their policy meeting will have to see projected rates rise to at least 3% by December, and most projected rates will need to rise to 3.75% next year.

The Fed’s preferred measure of inflation, the Personal Consumer Price Index, rose 6.3% in April of the previous year, close to a 40-year high.

With inflation well above the Fed’s 2% target and the economy growing solidly, many simple monetary policy rules “call for a significant raise in the target range for the federal funds rate,” according to the Fed’s semi-annual monetary policy report to Congress.

Federal Reserve Chairman Jerome Powell said the central bank’s goal is to bring inflation down to 2%. The Federal Reserve approved a 0.75 percentage point interest rate increase on Wednesday, the largest rate increase since 1994. Photo: Elizabeth Frantz/Reuters

However, the policy rules themselves have called for extremely negative values ​​for the Fed’s benchmark rate during the pandemic-driven recession of 2020, and the Fed cannot lower interest rates to these levels. As a result, the Fed has used other tools, including asset purchases and verbal liabilities to keep interest rates low for longer, to provide additional stimulus.

Such rules, including those introduced by Stanford University professor John Taylor in the early 1990s, are relatively easy to use and describe a close relationship between a small number of economic data points and the determination of short-term interest rates. Federal Reserve officials say they regularly use such rules to guide their management of monetary policy, but they caution against over-reliance.

The report said that the difficulty of providing traditional stimulus when interest rates are close to zero can lead to situations like the current situation, where interest rates remain well below the levels stipulated in policy rules, especially given the sharp shift in the economy and labor markets.

The report said that “the usefulness of simple policy rules can be limited in extraordinary economic circumstances” such as the current ones.

Mr. Taylor’s original paper that developed these rules also made similar observations by noting that monetary policy will at times have to address economic episodes that require “more than a simple policy rule as a guide”.

In general, rules calling for higher interest rates assume that most current inflation, excluding food and energy prices, comes from increased primary demand as opposed to individual shocks that can fade. Rules that use forward-looking forecasts that assume inflation will fall somewhat require interest rates closer to 4%. These rules also do not take into account how borrowing costs may have already increased based on the expectation of higher interest rates in the near future, nor do they represent the Fed’s ongoing efforts to shrink its $8.9 trillion asset portfolio.

Federal Reserve officials are raising interest rates at the fastest pace since the 1980s as they seek to quickly remove stimulus and then raise borrowing costs to levels that would deliberately slow the rate of economic growth. Officials noted that this could lead to a higher unemployment rate over the coming years, raising the risk of a recession.

Officials are particularly focused on ensuring that high inflation does not cause households and businesses to expect high price growth over the next few years. Economists believe that these inflation expectations can come true on their own and that they play a major role in determining actual prices.

While market gauges of inflation expectations have stalled in recent months, a survey last week showed consumers’ long-term inflation expectations rose to a 14-year high.

The Fed said its holding index of inflation expectations that gathers a broad range of such measures has risen this year and “now stands at the upper end of the range from the past 20 years.”

Federal Reserve Chairman Jerome Powell described a recent report on rising inflation expectations as “absolutely remarkable” at a press conference on Wednesday. He added that the Fed index itself “has risen after being flat for a long time, so we’re watching that, and we think that’s something we should take seriously.”

Separately, an economic model maintained by the Federal Reserve Bank of New York predicted that the economy could slow faster than previously expected to levels consistent with a recession next year. The model, which is not an official banking forecast, projects fourth-quarter economic growth to contract 0.6% from a year earlier, and forecast another 0.5% at the end of next year.

According to the model, a so-called soft landing in which annual GDP growth slows but remains positive over the next two and a half years has a probability of only 10%. Meanwhile, the probability of a hard landing, in which annual GDP growth falls below 1% in at least one quarter over the next two and a half years, is about 80%, according to the model’s estimates.

write to Nick Timiraos at

Inflation and the economy

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