The question often arises of which monetary policy rule the Fed uses in its analysis (I’m going to avoid the much more involved question of which monetary policy rule it should use).
In their latest commentary, the economics team at MF Global note:
“We realize Fed officials do not mechanically follow a Taylor Rule in setting monetary policy, and expectations for growth are being pared a little, but, based on the original Taylor Rule and adjusting for stimulus from balance sheet expansion, we calculate that the last set of Fed projections was consistent with about a 3% funds rate at the end of 2012.”
At today’s Monetary Policy Committee meeting, Andrew Sentance goes head-to-head with Adam Posen in a bid to sway the mushy middle of the Bank of England’s MPC to his point of view. Like most analysts, the betting is that neither will succeed and the Bank will leave policy unchanged with interest rates at 0.5 per cent and a stock of £200bn of assets purchased under the programme of quantitative easing.
As a paid-up member of the mushy crowd, I share Mr Posen’s theoretical concern that deficient demand will have permanent effects, but also Mr Sentance’s observation that the evidence for these worries is lacking.
So, following Robin’s good practice and the wise words of Fed chairman Ben Bernanke from January, I wondered whether the use of a simple rule of thumb – a Taylor Rule – could help guide us where UK interest rates should be going.
The short answer is no.
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
Sharp-eyed observers are zeroing in on a chart (below) used by Ben Bernanke in his address to the American Economic Association at the weekend that appears to show the optimal interest rate based on a forward looking Taylor rule with a PCE measure of inflation was zero in early 2009 – and not a negative number.
This appears to conflict with earlier studies – including an internal Fed staff analysis I wrote about last year – that used modified Taylor rules to show that the optimal interest rate in early 2009 was well below zero – for instance, minus five per cent. Such analysis supported the case for large scale asset purchases as a proxy for negative rates.