I wrote a piece in today’s paper flagging up the fact that the version of the Taylor rule cited by Bernanke in his AEA speech has recommended a positive interest rate since mid-2009. This raises the question of whether the Fed is still pinned to the zero bound (ie it would be running negative rates if it could) or whether a relatively modest upside forecast revision could lead to early rate hikes.
The calculation used by Bernanke – based on Fed forecasts over four quarters using PCE to measure inflation with equal coefficients for both sides of the dual mandate – suggests the Fed is not pinned to the zero bound any more and that the ideal interest rate is a fraction above zero. Which implies that a mid-sized forecast upgrade could start discussion of rate hikes.
However, my sense is that when it comes to policy Fed policymakers will a) put greater weight on the unemployment gap than the inflation gap in terms of Taylor rule-style calibration (see eg research by the SF Fed) b) deem that the neutral rate has probably fallen a lot from the normal Taylor rule assumption of 2 per cent.
Adjust the AEA chart series to take this into account and the Fed still seems to be pinned to the zero bound ie it will be a while before it raises rates unless there is a big upgrade to its forecasts. That is consistent with the guidance language on rates.
But, the basic insight from the original chart – that there is not anything like as much of a cushion between the rate the Fed has and the rate it would ideally have now than there was in early 2009 – still holds.
If the outlook gradually strengthens over the first half and we get decent jobs growth by midyear, the debate about rate increases will indeed start in earnest.
