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- Not quite Taylored fit
Ten years ago, the U.S. House of Representatives debated legislation to limit the Federal Reserve's (Fed’s) freedom to set monetary policy as it sees fit.[1] such proposals used to be very popular among Republican policymakers, but highly controversial among many economists.[2] Both perspectives have a certain appeal. In a world where policymakers knew all relevant economic data in real time, a monetary-policy rule that simply relied on data about growth and inflation, say, would make monetary policy more predictable and insulate it further from political interference.
The best known such rule, underpinning the 2014 House legislation, was developed and named after Stanford economist John Taylor in the 1990s. The Taylor rule uses inflation and the output gap, a measure of how far above or below aggregate demand in an economy is compared to how much can be produced without accelerating inflation.[3] For the 15 years leading up to the 2008 Great Financial Crisis (GFC), it seemed to work reasonably well. During the GFC, though, output crashed, prices deflated and various versions of the Taylor rule were calling for negative interest rates. Since cutting rates below zero is technically tricky, the Fed increasingly turned to unconventional monetary policies, such as quantitative easing.
When and how far U.S. rates should fall is quite a judgement call
Sources: Haver Analytics, DWS Investment GmbH as of 6/4/24
Fast forward 10 years from those 2014 House debates, and another problem with making monetary policy rule-bound moves sharply came into focus: Both inflation and economic growth can be measured in various ways and are vulnerable to data revisions. Economic data series also contain plenty of random noise, while some important variables (such as the output gap) can only be estimated.
Taking inflation, as measured by the Fed's preferred measure, the core personal consumption expenditures (PCE) price index, and a number of reasonable assumptions, including the Fed's preference for continuity, the Taylor-rule would suggest a federal funds rate (FFR) of 5.27% - just below the current effective FFR. But for how long? Part of that depends on how quickly labor markets continue to react to high interest rates. In our Chart of the Week, we use just one of many possible ways to assess the state of the labor market and use this to calculate how high interest rates should now be based on labor markets alone. According to this calculation interest rates should be for the labor markets to return to equilibrium in the medium term just under 3 percent.[4]
“The bottom line is that monetary policy is clearly restrictive from a labor-market perspective. Current inflation metrics, however, still do not warrant a cut,” argues Christian Scherrmann, U.S. Economist at DWS. “No wonder the Fed sees balanced risks and keeps a close watch as well as an open mind on incoming data.” In the real world full of complexity and measuring errors, shackling the Fed to a single policy rule always seemed like a bad idea. But arguably, the other extreme is even worse: letting elected politicians interfere with rate setting directly, rather than having an independent central bank which publicly commits to a stable framework and is held accountable for how well it achieves its monetary-policy objectives.
