“Behind the curve”: a monetary saga
We were recently reminded of the story of a well-known monetary economist who was always late for meetings. When a colleague points out his usual lateness, the economist responds that he is never really late.
He always left on time, but his arrival time was shifted and variable.
The Federal Reserve has rightly received widespread criticism for its delayed response to rising inflation and its misguided assertion that it is “transitory.” In the buzzword repeatedly used to describe the situation, the Fed was “behind the curve.»
Today, it is fashionable again to complain about the Fed’s slow response to economic changes. But this time, critics argue that the Fed is being too hesitant to lower interest rates. If the Fed continues to hold rates steady through the spring and early summer, we can expect these complaints to become louder and more frequent.
“Restrictive” or simply misunderstood?
Federal Reserve Chairman Jerome Powell has often described central bank policy as follows: “restrictive.” Proponents of an early rate cut argue that monetary policy becomes more restrictive as inflation falls, because real interest rates increase even if nominal rates remain stable.
The logic is quite simple to follow. If the federal funds rate is 5.40 percent and inflation is 3.4 percent, the real rate is two percent. (There are other ways to calculate the real rate – some analysts prefer to use a measure of expected inflation – but the differences are irrelevant on this point.) If inflation falls to 2.4% then the rate federal funds remains unchanged, the real rate increases. at three percent.
Proponents of lowering rates argue that if inflation is already falling, it doesn’t make sense to tighten monetary policy this way. If the Fed believes that inflation is sufficiently restrictive currently, it should cut rates to keep pace with falling inflationsays the argument.
Moreover, they say, the effects of monetary policy only act on the economy with long and variable lags. Thus, the rate hikes implemented by the Fed last year could still have repercussions on the economy. If the Fed were to wait to make cuts until the economy slows significantly, it would risk once again falling “behind the curve” and perhaps even falling behind the curve. send the economy into a recession.
In a survey released Monday, the National Association for Business Economists found that 21 percent of respondents believe that the Fed’s policy is too restrictive. Although this is still a minority opinion, it is the highest since mid-2010.
The economic challenge march
The problem with this view today is that the economic data does not at all support the idea that the monetary policy stance is very tight. The Federal Reserve believes that the economy’s potential long-term growth is a mere 1.8 percent. Since the Fed began raising rates, the economy has never grown at or below this pace.
As for the idea that the effects are lagged, the data points in the opposite direction: the economy has accelerated as we travel the corridors of time since the first rate increase. The economy grew 4.9% in the third quarter of last year, 3.3% in the fourth quarter, and GDPNow is growing at 3.4%.
Laurent Lindsey asks in a recent memo to Lindsay Group clients: “If the policy is restrictive, what exactly is restricted?” Lindsey points out that the Federal Reserve’s Summary of Economic Projections (SEP) shows that Fed officials estimate the long-term inflation rate to be 2% and the long-term federal funds rate to be 2.5%. . In other words, they view the real long-term interest rate as a simple 0.5 percent.
It was not always this way. In 2014, the Federal Reserve projected that the long-term federal funds rate would average 4.3%, resulting in a real rate of 2.3%. As Lindsey points out, the famous “Taylor’s rule” was based on the observation that the real long-run equilibrium rate is around 2 percent.
Between 2014 and 2016, the Fed lowered its long-term interest rate forecast from about 4% to about 3%, effectively cutting the implied real rate in half. The rationale was that growth appeared sluggish and inflation was consistently below the Fed’s 2% target. In 2019, the Fed’s SEP showed the the longer-term estimate falls to 2.5 percent– where he has remained ever since.
It is a remarkable asymmetry. When inflation remained below the Fed’s target, the estimated real rate was pushed down. But even when inflation soared and lasted longer than Fed officials expected, the long-term real rate remained completely unchanged. The Fed continued to project 2% inflation and a 2.5% federal funds rate throughout this episode.
The “woke” Taylor rule
A lot of expectations that the Fed would reduce several times this year – and the growing perception that monetary policy is too tight – seems based on the assumption that this will not change. In other words, the Fed will remain committed to the idea that the real rate should be around half a percentage point and therefore the federal funds rate will “normalize” around 2.5%. Lindsey calls this the “wake up» version of Taylor’s rule.
However, this assumption could turn out to be incorrect. Recent economic performance suggests that the real rate consistent with sustainable growth and two percent inflation is more than half a percent.
Hopefully the Fed will realize this soon enough. Unfortunately, we expect that awareness of the need to raise real rates will arrive no more in time than the shifty and fluctuating economist.