Is the Fed Behind the Curve?

Imagine Fed Governor Rip van Winkle started his nap at the beginning of 2007 and just woke up to find that inflation is close to the Fed’s objective and the unemployment rate is at its 30-year average. You could forgive him for expecting the federal funds rate to be close to its long-run norm of about 4%, and for his surprise upon learning that the funds rate is at 0.1% and Fed assets are five times where they were when his snooze began.

Is the Fed already behind the curve? Why do policymakers emphasize their expectation that rates will stay low “for a considerable time” beyond October (when asset purchases are expected to halt)? What risks are they seeking to balance?

The most common benchmark for monetary policy is the Taylor rule, which relates the central bank’s policy rate to a combination of deviations of inflation from its target and a measure of resource slack. The modified Taylor rule in the chart below shows that – even ignoring the Fed’s balance sheet expansion – the Fed’s interest rate policy is now unusually stimulative by the standard of the past three decades. [The blue line in the chart is based on the Fed’s preferred inflation measure, the price index of personal consumption expenditures, and the deviation of the unemployment rate from its equilibrium level as a measure of slack.]

U.S. Federal Funds Rate vs. Modified Taylor Rule, 1985–May 2014

Note: The modified Taylor rule shown is R = r + Inflation + 0.5x(Inflation – 2) – (Ut – U*), where: (1) R is the federal funds rate; (2) r is the equilibrium real interest rate (set to 1.75 in line with the midpoint of FOMC members’ projections for the federal funds rate and the inflation rate in the longer run); (3) inflation is measured by the annual percent change of the price index of personal consumption expenditures; (4) Ut is the unemployment rate; and (5) U* is the equilibrium unemployment rate (set to 5.35% in line with the midpoint of FOMC members’ projections for the longer run).


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