The Federal Reserve’s economic outlook has dimmed noticeably over the past nine months. Monetary policymakers now expect both economic growth and inflation to be slower than they had anticipated last September. Policymakers’ projections for the path of their own interest-rate target have ratcheted down even more. Last fall, Fed officials expected to raise rates three times in 2019 and once more in 2020. Now, by sharp contrast, they expect to cut rates at least once before the end of next year.
Stanford economist John Taylor’s famous monetary policy rule helps make sense of the Fed’s shifting expectations. The Taylor Rule neatly breaks the change in projected policy rates into two components: one attributable to slower growth and inflation, and the other reflecting forecasts of lower interest rates in the long run. Fed officials could use the Taylor Rule in this way, to explain more clearly the rationale for their policy decisions and emphasize that those decisions are based on economics alone, independent of political pressure.
The Federal Reserve releases its Summary of Economic Projections (SEPs) four times each year. These SEPs collect Federal Open Market Committee (FOMC) members’ forecasts of output growth and inflation, as well as their projections for the most likely path of their federal funds rate target. The table below compares the SEPs from last September to those released last week.
The table’s first two rows show that the median of FOMC members’ forecasts of real GDP growth for 2019 declined from 2.5% to 2.1%, even as their expectation of long-run growth increased slightly, from 1.8% to 1.9%. Taken together, these two sets of numbers imply that, in the FOMC’s view, the growth rate of the U.S. economy relative to its long-run potential has fallen by 0.5%. At the press conference following last week’s FOMC meeting, Fed Chairman Jerome Powell attributed this expected slowdown in growth to weakness in the global economy and a decline in U.S. business confidence reflecting concerns over international trade policies.
The table’s next row shows that the median forecast of core inflation in 2019, as measured by changes in the price index for personal consumption expenditures (PCE) excluding food and energy, declined from 2.1% to 1.8%. Whereas last fall, policymakers expected inflation to run slightly above their 2% long-run target, now they see it falling slightly below.
Finally, the table shows that the FOMC’s median expectation for the federal funds rate target has fallen from 3.1% to 2.4% for 2019 and from 3.4% to 2.1% for 2020. The midpoint of the FOMC’s target range for the funds rate was raised to 2.4% at the end of 2018, where it remains today. As of last September, therefore, FOMC members were expected to make four quarter-point hikes in the funds rate through the end of 2020. Today, instead, they are expected to reduce rates at least once.
John Taylor’s interest rate rule, introduced in a now famous paper delivered in 1993, helps make sense of all these numbers. The Taylor Rule takes the form:
r = r* + 1.5(p - 2) + 0.5y
In the equation, r is the prescribed funds rate target, r* (often referred to by Fed officials as “r-star”) denotes the long-run or “neutral” level of the federal fund rate, p - 2 measures the deviation of inflation p from the 2% target, and y is the output gap. In words, the Taylor Rule dictates that the funds rate should be above or below r-star depending on whether inflation is above or below target and whether output is above or below its long-term potential.
The coefficients of 1.5 on inflation and 0.5 on the output gap, originally suggested by Taylor, imply that the 0.3% decrease in the FOMC’s forecast for inflation and the 0.5% decrease in the forecast for output growth relative to potential call for a reduction in the expected funds rate target of 0.7%. Thus, the systematic response of monetary policy to changes in the state of the economy prescribed by the Taylor Rule accounts for more than half of the 1.3% reduction in the FOMC’s funds rate projection for 2020.
The remainder of the decline in the expected funds rate is explained by the 0.5% reduction in the FOMC’s forecast for r-star—the long-run federal funds rate, shown in the table’s last row. The reasons for this substantial, and rather abrupt, downward adjustment to the estimate of r-star were not discussed, either in the FOMC’s official policy statement or in Chairman Powell’s press conference after last week’s FOMC meeting. But perhaps it reflects the fact that inflation’s return to target continues to be frustratingly slow. This observation suggests that the long-run neutral rate of interest cannot be much higher than the current 2.4% setting of the federal funds rate.
Although FOMC members typically resist calls to describe their policy decisions with reference to the Taylor Rule, this exercise illustrates the gains they would enjoy from doing so. With reference to the Taylor Rule, policymakers could explain more easily that the substantial downward adjustment to their expected interest-rate path represents a deliberate response to changes in their outlook for economic growth and inflation, together with their best judgement that r-star is considerably lower than previously thought. Even more important, they could use the Taylor Rule to demonstrate that their interest rate decisions are driven by economic analysis alone and not influenced by political pressure.
Finally, by using the Taylor Rule to link changes in the expected funds rate to a small set of more basic economic forces, the FOMC could sharpen evaluations of its policy process. Certainly, forecasts for inflation running persistently below target justify caution in raising interest rates above their current levels. But, as noted above, FOMC members have not fully explained why their estimate of r-star declined so dramatically, from 3% to 2.5%, over the past nine months alone. The FOMC’s short and long-run forecasts for GDP growth, both close to 2%, also deserve further consideration. Given that real GDP grew by almost 3% last year and registered a similar gain for the first quarter of 2019, the FOMC may well be too pessimistic about growth prospects for the U.S. economy. If so, expectations may quickly shift back towards further interest-rate increases later this year.
Peter Ireland is a professor of economics at Boston College and a member of the Shadow Open Market Committee.
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