“Behind the Curve”: The Financial Story
We were recently reminded of the story of a famous financial economist who was always late to meetings. When his colleague pointed out that he was habitually late, the economist replied that he was never actually late.
He always left on time, but his arrival time was Delays and fluctuations.
Understandably, the Fed has received a lot of criticism for its slow response to the spike in inflation and its hasty judgment that it was a “temporary event.” In a popular phrase repeatedly used to describe this situation, the Fed said:behind the curve.”
Now it’s popular again to complain that the Fed is too slow to react to economic changes. Only this time, critics say the Fed is being treated unfairly. Too hesitant to lower interest rates. If the Fed continues to hold interest rates unchanged throughout the spring and summer, these complaints are expected to grow louder and more frequent.
“Restrictive” or just a misunderstanding?
Federal Reserve Chairman Jerome Powell often describes central bank policy this way:restrictive” Proponents of early interest rate cuts argue that monetary policy is becoming more restrictive as inflation declines. real interest rate Although nominal interest rates remain unchanged, they are rising.
The logic is very easy to understand. For the federal funds rate, 5.40 percent and the inflation 3.4 percent, the real interest rate is 2 percent. (There are other ways to calculate the real interest rate, some analysts prefer to use a measure of expected inflation, but the difference is not important in this regard.) While the federal funds rate remains unchanged. When inflation falls to 2.4%, real interest rates rise. up to 3 percent.
Proponents of rate cuts argue that it makes no sense to tighten monetary policy in this way if inflation is already falling. If the Fed believes inflation is currently sufficiently contained, it should do so. lower interest rates to keep pace with falling inflationthe discussion continues.
Furthermore, they say that the effects of monetary policy only affect the economy. long fluctuating lag. So the Fed’s interest rate hikes last year may still be having an effect on the economy. If the Fed waits to cut rates until the economy slows significantly, it will once again become “outdated” and possibly bring the economy into recession.
In a study released Monday, the National Association of Business Economists found that: 21 percent A percentage of respondents say the Fed’s policies are too restrictive. Although this is still a minority view, this is the highest amount since mid-2010.
economic rebellious march
The problem with taking this view today is that economic indicators do not support the idea that the stance of monetary policy is very restrictive. The Fed estimates that the economy’s long-term potential growth rate is only modest. 1.8%. The economy has never grown less than that pace since the Fed started raising interest rates.
Regarding the idea of delayed effects, evidence points in the opposite direction. economy is accelerating We have moved down the corridor of time since the first rate hike. The economy grew at 4.9 percent in the third quarter of last year, 3.3 percent in the fourth quarter, and is growing at a pace of 3.4 percent, according to GDPNow.
Lawrence Lindsay In a recent note to Lindsay Group clients, asks, “If a policy is restrictive, what exactly is it restricted?” Lindsey noted that the Fed’s Summary Economic Projections (SEP) shows that Fed officials see long-term inflation at 2% and the long-term federal funds rate at 2.5%. In other words, they think of long-term real interest rates as just that. 0.5 percent.
It wasn’t always like that. In 2014, the Fed expected the long-term federal funds rate to average 4.3% and the real interest rate to be 2.3%. As Lindsey points out, John Taylor’s famous “taylor rules” is based on the finding that the long-run equilibrium real interest rate is approximately 2%.
From 2014 to 2016, the Fed lowered its long-term interest rate expectations from about 4% to about 3%, cutting the implied real interest rate in half. The rationale for this was that growth appeared to be slowing and inflation remained consistently below the Fed’s 2% target. In 2019, the Fed’s SEP showed: Long-term forecast drops to 2.5%-A place that has remained ever since.
this is significant asymmetry. If inflation was persistently below his Fed’s target, the estimated real interest rate would be pushed down. But even as inflation spiked higher and for a longer period of time than Fed officials expected, long-term real interest rates did not change at all. The Fed continued to forecast 2% inflation and a 2.5% federal funds rate throughout the episode.
“Wake” Taylor Rule
lots of Expectations that the Fed will cut interest rates There has been widespread recognition many times this year that monetary policy is too restrictive, and the assumption seems to be that this will not change. That means the Fed remains committed to the idea that real interest rates should be around 0.5 percentage point, so the federal funds rate will “normalize” around 2.5%. Lindsay calls this “woke up” version of the Taylor rule.
However, this assumption may prove to be incorrect. Recent economic performance suggests that real interest rates that are compatible with sustainable growth and 2% inflation are higher than 0.5%.
With any luck, the Fed will recognize this soon. Sadly, we expect that the realization that real interest rates need to be higher may not arrive as quickly as it would for a lagging economist.
