Given the recent confusion as to the Federal Reserve’s current stance, it seems like a fine time for a quick look at the “Taylor rule.” That’s an equation economists and Fed watchers like to use to see what the central bank’s federal funds rate ought to be given broad conditions in the macroeconomy. The inputs to the rule are inflation and unemployment and its output is the expected fed funds rate.
A relevant advantage to the rule at a time like this is that since it’s just an equation it’s not bound by zero (as are nominal rates). The fact that it’s been negative since 2009 has been a strong motivator for the Fed’s alternative measures, like quantitative easing.
Before plotting the inputs, let’s think for a minute about what they’re probably saying. Basically, unemployment is stuck a couple of percentage points above where it would be at full employment and inflation has been low and slow. Those are trends associated with an economy asking for continued, not “tapered” monetary stimulus (fiscal too, of course, but Congress is beyond hopeless in this regard—they’re, i.e., House R’s—busy trying to kill food stamps). Bernanke himself made similar points late last week.
As you can see in the figure below, inflation has been decelerating. The line for unemployment in the figure is actually the unemployment gap, or the CBOs estimate of the unemployment rate associated with full employment minus the actually unemployment rate. When that line hits zero, the economy’s at full employment, as per CBO at least. It’s been consistently drifting up, a good thing for sure, but it’s still two big points below zero.
Source: BLS, BEA, CBO; The 2013q2 observation for inflation is from May13/May12, i.e., monthly data since the quarterly PCE deflator is not yet available.
Plug these values into the Taylor rule* and you get the figure below. As the recovery has proceed it has drifted up, but it’s still a negative, implying that the zero-lower-bound on the federal funds rate is still a serious macroeconomic constraint on policy. Moreover, it’s been camping out at between -1 and -2 percent for the past two years.
Source: See text
So, you look at those pictures and you can sort of see how the Fed might feel compelled to reasonably say, “Yo, markets…at some point things will have to start getting back to normal” though there are good questions as to whether the necessary uncertainty embedded in “at some point” is really worth getting skittish investors all lathered up over.
But given inflation’s deceleration and the still-large two point output gap,* you can also see an economy that’s clearly not ready to come off the medication.
*I used this version: 2+p+(0.5(p-2))+y where p is year-over-year percent change in the PCE inflation index and y is the output gap: 2*(nairu-unemp) where 2 is the Okun coefficient and the nairu is from CBO.
**Looking at Figure 1 above, close observers may wonder why inflation is slowing while the output gap is closing. Shouldn’t a closing output gap be associated with faster price growth? Isn’t that the whole basis of the NAIRU? We’ve got to watch out for unemployment getting too low or it will lead to spiraling price growth! Right??!! Um…maybe not so much, especially in recent cycles. But more on that some other time.