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A Rule That Makes Sense Of The Fed

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  • Monetary policymakers now expect both economic growth and inflation to be slower than they had anticipated last September.
  • Whereas last fall, policymakers expected inflation to run slightly above their 2% long-run target, now they see it falling slightly below.
  • By using the Taylor Rule to link changes in the expected Funds rate to a small set of more basic economic forces, the FOMC could sharpen evaluations of its policy process.

By Peter Ireland

The Federal Reserve's economic outlook has dimmed noticeably over the past nine months. Monetary policymakers now expect both economic growth and inflation to be slower than they had anticipated last September. Policymakers' projections for the path of their own interest-rate target have ratcheted down even more. Last fall, Fed officials expected to raise rates three times in 2019 and once more in 2020. Now, by sharp contrast, they expect to cut rates at least once before the end of next year.

Stanford economist John Taylor's famous monetary policy rule helps make sense of the Fed's shifting expectations. The Taylor Rule neatly breaks the change in projected policy rates into two components: one attributable to slower growth and inflation, and the other reflecting forecasts of lower interest rates in the long run. Fed officials could use the Taylor Rule in this way, to explain more clearly the rationale for their policy decisions and emphasize that those decisions are based on economics alone, independent of political pressure.

The Federal Reserve releases its Summary of Economic Projections (SEPs) four times each year. These SEPs collect Federal Open Market Committee (FOMC) members' forecasts of output growth and inflation, as well as their projections for the most likely path of their Federal Funds rate target. The table below compares the SEPs from last September to those released last week.

The table's first two rows show that the median of FOMC members' forecasts of real GDP growth for 2019 declined from 2.5% to 2.1%, even as their expectation of long-run growth increased slightly, from 1.8% to 1.9%. Taken together, these two sets of numbers imply that, in the FOMC's view, the growth rate of the U.S. economy relative to its long-run potential has fallen by 0.5%. At the press conference following last week's

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Comments (1)

Lawrence J. Kramer profile picture
"in the FOMC's view, the growth rate of the U.S. economy relative to its long-run potential has fallen by 0.5%."

The tables refer to long-run RGDP, not current, short-run potential, which I would think is the true measure of the output gap. How does the Fed have a clue as to the long-run POTENTIAL RGDP (even if we ignore the surge in foreign goods that US money can chase)? What with AI and robotics, our potential RGDP right now may be, literally, off the charts. Just create some demand and watch the factories pop up. Could it be that low rates have failed to juice inflation because the output gap is increasingly negative, that no matter how much money the banks create by lending against future production and the Fed creates by monetizing the fiscal deficit, the money can't catch up with the goods?

Eventually, skilled workers become a bottleneck, but every day someone figures out a solution to that problem that does not involve creating more skilled workers. Moore's law has escaped the computer room and spread to the factory floor. I just wonder to what extent the Fed has grappled with this changing supply curve, and, especially, the extent to which potential capacity should be counted as current capacity because it can be brought into existence and production so quickly.
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