When should the Fed raise rates? (even more wonkish) »
Posted By tehranchik 2 months, 2 weeks ago in Business & FinanceLet me start with a rounded version of the Rudebusch version of the Taylor rule:
Fed funds target = 2 + 1.5 x inflation - 2 x excess unemployment
where inflation is measured by the change in the core PCE deflator over the past four quarters (currently 1.6), and excess unemployment is the different between the CBO estimate of the NAIRU (currently 4.8) and the actual unemployment rate (currently 9.8).
Right now, this rule says that the Fed funds rate should be -5.6%. So we’re hard up against the zero bound.
Suppose that core inflation stays at 1.6% (although in fact it’s almost sure to go lower.) Then we can back out the unemployment rate at which the target would cross zero, suggesting that tightening should begin: it’s an excess unemployment rate of 2.2, implying an actual rate of 7 percent. That’s a long way from here. If inflation drops to, say, 1 percent, the Fed shouldn’t tighten until unemployment drops to 6.25%.
What would it take to get to that range of unemployment? Okun’s Law suggests that it takes 2 points of GDP growth in excess of potential to reduce unemployment by 1 point. Potential growth is probably around 2.5. So say we have 5 percent growth for the next 2 years — which would be hailed as a stunning boom. Even so, unemployment should fall only 2.5 points, to 7.3. In other words, even with a really strong recovery (which almost nobody expects), the Fed should keep rates on hold for at least two years.
Bear in mind that I’m using entirely standard, conventional analysis here. It’s the people saying that the Fed should start tightening in the near future who are inventing some kind of new, unspecified framework to justify their views.
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tehranchik
Well, I'm from and live in the Pacific Northwest. I did live in the middle east during the late 70's and early 80 ...
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