The First Rule of Monetary Policy
How the Fed dropped the ball on inflation
It sure seems like the Fed has “dropped the ball” on inflation, at least it does to me. I have already made this point a couple times here and here. It seems that some Fed insiders think so as well, given recent panicky comments made by some officials.
Okay, so how did they drop the ball? Answering that question involves understanding how the Federal Open Market Committee (FOMC) makes its decisions. That comes down to a topic in monetary economics known as “rules” versus “discretion.” Let’s start with the latter.
The Just Do It Approach
Discretion means what it means in regular, every-day language: choice or judgement. For the Fed, that means having the freedom to use their judgement to carry out their job to stabilize the economy. What this process is exactly, is not clear. The FOMC does not follow a specific roadmap or decision rule tree (or something like that) when deciding whether or not to change interest rates and by how much. They obviously make forecasts and use those forecasts as a guide, but we as the public do not know exactly how the FOMC committee incorporates that information in real time. We can go back five years and read the FOMC’s detailed discussions, but for recent meetings we cannot (the Fed publishes those transcripts with a five-year lag here). If you do read those now-ancient discussions you see discretion at work. They consider the economy from all angles and then ultimately form some sort of consensus on the economy based on that discussion.
Frederic Mishkin—notable macroeconomist, textbook author, and former member of the Fed’s Board of Governors—calls the FOMC’s use of discretion the Just Do it Approach.
Of course, the Just Do it Approach is not completely free of some “guiding values” on what to do. The Fed has suggested that they target the long run inflation rate to be 2 percent. And, while they don’t state it explicitly, the consensus among macroeconomists is that the “right” unemployment rate is around 4 to 5 percent. In the least, those guiding values are what macroeconomists think will keep the macroeconomy growing at its potential. However, the Fed and the members of the FOMC have the discretion to manipulate the economy when and how they see fit.
What is an alternative to the Just Do it Approach? One alternative is to follow a “policy rule.”
The First Rule of Monetary Policy
The first rule of monetary policy is that there is no rule for monetary policy, at least as practiced by the Fed in 2022.1
But, there is a rule that can help us compare and contrast what the Fed is doing—or has not been doing. That rule provides insight into how—if the rule was followed—the FOMC might have responded to the increasing inflation rate we have experienced.
First, what do I mean by “rule”? A policy rule provides specific guidance on how to combat a rise in inflation or a rise in unemployment. The rule provides a simple and automatic instruction to follow to tell policy makers when to change the interest rate and by how much.
What would such a rule look like? The most famous (among monetary economists) version of a policy rule is known as the “Taylor Rule.” The Taylor Rule is named after the macroeconomist John Taylor who conceived of the rule in a 1993 paper. Since then there has been volumes of research on the Taylor Rule and policy rules in general.
The simplest version of the Taylor Rule looks like this (where FFR is the “federal funds rate”):
Nominal FFR = Inflation + LR Real FFR + 0.5*(Output Gap) + 0.5*(Inflation Gap)
The Nominal FFR is a function of four components:
The current inflation rate.
The long run (LR) “equilibrium level” of the real federal funds rate (the level consistent with potential GDP growth).
The output gap.
The inflation gap.
I have discussed the output gap before. The inflation gap is an analogous concept, where the gap is written as follows:
Inflation Gap = Current Inflation – Inflation Target
The “Inflation Target” is the value the Fed is shooting for, 2 percent in practice.
There are a few important things to notice about the Taylor Rule:
If the output gap and the inflation gap are zero, then the nominal FFR equals current inflation plus the long run FFR. Or, the real FFR equals the long run real FFR.
The output and inflation gaps will equal zero when the economy is growing at a rate equal to potential GDP. Or, to put it another way, the business cycle has landed exactly on that growth rate (as discussed here).
The 0.5 in front of both the output gap and the inflation gap are referred to as the “weights” on those gaps.
It is the real interest rate that matters. The rule implies that the Fed needs to raise the nominal interest rate higher than the real interest rate (again, as discussed here). This idea is known as the Taylor principle.2 I will say more on this later.
What does this imply for recent policy?
Table 1 shows the values for the PCE rate of inflation (the price index the Fed focuses on) and real GDP growth. Also, I assume that potential GDP growth is 2 percent (based on the growth rate I calculated in a previous post), and the target rate of inflation is 2 percent. The long run value for the FFR is 2.4 percent (based on the Fed’s projections).
We can calculate the value of the nominal federal funds rate that the Taylor Rule would produce, based on what happened in 2021.3
Nominal FFR =(5.78) + (2.4) + 0.5*(3.53) + 0.5*(3.78)
Nominal FFR = 11.84 percent
This means that in order to close the output and inflation gaps (i.e., tame our recent high rates of inflation), the nominal interest rate should be set to 11.84 percent! The Taylor Rule, in other words, is suggesting a serious hike in the nominal interest rate.
What is the current Federal Funds rate? The current nominal federal funds rate is 0.33 percent. According to this policy rule, the Fed is off the mark by 11.51 percent.
Yikes!
The Second Rule of Monetary Policy
The second rule of monetary policy is that there is no rule for monetary policy, to our recent and (likely) future misfortune.
To summarize, the Taylor Rule is an example of a “policy rule”—a relatively simple way to set policy. That rule, given the values for the output gap and the inflation gap in 2021, suggest that current monetary policy is far off from where it needs to be. In terms of the real federal funds rate, the situation is even more alarming.
Given the current nominal federal funds rate and the rate of inflation for 2021, the current real federal funds rate is,
Current Real FFR = 0.33 - 5.78 = -5.45 percent
Notice that reads as negative 5.45 percent. According to the Taylor Rule, that value needs to be a positive 6.06 percent (11.84 - 5.78).
The Taylor Rule example in this post underscores points made by macroeconomists such as Lawrence Summers and Scott Sumner—as I cited and emphasized in my last post. The Fed is not only failing to be “tight” enough, they are, in fact, still engaged in expansionary policy. Why? Because the real interest rate is negative (you could use current inflation rates to make that point as well, instead of the 2021 values as I have done here).
The Taylor Rule calculated above implies that the Fed should be implementing a positive real Federal Funds rate; and that would require the current nominal funds rate to be at least around 11 percent. Why do we need a positive rate? Because a positive real rate would be contractionary. In order to cool off the rate of inflation—we need contractionary policy, not expansionary.
I close this post with a quote from Frederic Mishkin’s textbook, which helps emphasize the points made in this post (from page 404 in the 10th edition; bold font added by me for emphasis):
The principle that the monetary authorities should raise nominal interest rates by more than the increase in the inflation rate has been named the Taylor principle, and it is critical to the success of monetary policy. Suppose the Taylor principle is not followed and nominal rates rise by less than the rise in the inflation rate, so that real interest rates fall when inflation rises. Serious instability then results because a rise in inflation leads to an effective easing of monetary policy, which then leads to even higher inflation in the future.
In other words, uh-oh.
Original picture downloaded from knowyourmeme.com and modified by me.
This overview of the Taylor Rule is based on Frederic Mishkin’s textbook, which I have used over my many years teaching courses related to monetary policy and macroeconomic theory. My notes for those courses have primarily been based on the textbook by Frederic Mishkin, “The Economics of Money, Banking, and Financial Markets.” I have also used a book by Wendy Carlin and David Soskice, "Macroeconomics: imperfections, institutions, and policies.”
In Taylor’s 1993 paper he defines the output gap as the percentage deviation of output from its target level. I am using Mishkin’s slightly simpler version of the output gap (from the 10th edition of his textbook).