Fed’s Rate Increases Defy All the Rules

In theory, a central bank’s interest-rate moves should be related in some systematic way to its goals and to economic and financial data, a relationship economists and market participants refer to as a policy rule or reaction function. This helps investors understand and anticipate the Fed’s policy actions, bolstering their effectiveness.

The world is complicated, and no Fed chairman or chairwoman has ever been bound by a single rule or reaction function. That is especially true of

Jerome Powell,

who favored tightening policy at a glacial pace from 2020 through late 2021, but since March has raised rates at breakneck speed to combat high inflation. This has confused markets and heightened the risk the Fed ultimately lifts rates too much.

The debate over the merits of rules vs. discretion is almost as old as central banking. The gold standard was the original policy rule: Maintain the currency’s convertibility to gold. Even that, however, left plenty of room for discretion, such as in war and market panics, as the British essayist and journalist

Walter Bagehot

noted in his 1873 classic “Lombard Street: A Description of the Money Market.”

“The practical difficulties of life cannot be met by very simple rules; those dangers being complex and many, the rules for encountering them cannot well be single or simple,” Mr. Bagehot wrote. “A uniform remedy for many diseases often ends by killing the patient.”

In 1993, the economist

John Taylor

sought to explain recent Fed policy under chairmen

Paul Volcker

and

Alan Greenspan

with a rule. It sets interest rates at “neutral”—a level that keeps inflation and unemployment stable over time—then adjusts them based on how far inflation is from the Fed’s target, now 2%, and how much slack the economy has (such as how far unemployment is from its natural rate, the lowest possible without spurring inflation, now estimated at 4%).

As Mr. Bagehot noted, though, there will always be circumstances policy makers don’t anticipate. Fed officials, for example, argue that what is known as the Taylor rule isn’t suited to depressed economic conditions that call for negative interest rates.

The “Fed has never explicitly tied our monetary policy decisions to any formula, including Taylor rules,” Mr. Powell said last month. Nonetheless, “Taylor rules are ubiquitous…Some kind of Taylor rule is very much part of the way we think.”

Indeed, the Fed regularly publishes prescriptions of the Taylor rule and its derivatives. One is an “inertial” rule, which emphasizes past—as opposed to current or forecast—unemployment and inflation. In August of 2020, the Fed adopted an inertial rule: Instead of setting interest rates to hit 2% inflation, it would keep rates lower if inflation had run below 2%, aiming to spur it above 2% for some period so it would average 2% over time. Unemployment, no matter how low, wouldn’t be a reason to raise rates.

This new approach grew out of a belief that the Fed had over the previous decade overestimated the natural unemployment rate and neutral interest rate, resulting in too-tight monetary policy, forgone job opportunities and below-target inflation.

Inertial rules, though, are prone to undershooting or overshooting when the economy changes, which is what happened last year as high inflation proved more persistent than the Fed expected. So the central bank abandoned that approach in favor of focusing on the latest inflation data. In June, Mr. Powell said the Fed would keep tightening swiftly until it saw “compelling evidence that inflationary pressures are abating… in the form of a series of declining monthly inflation readings.”

This approach resembles a “first-difference” rule, which can be summarized as: Keep raising interest rates until inflation is almost back to target. Sure enough, with inflation staying high through the summer, Mr. Powell has delivered three consecutive 0.75 percentage point increases, bringing its benchmark federal-funds rate to just over 3%, the fastest tightening in over 40 years.

The advantage of a first-difference rule is that it doesn’t depend on the neutral interest rate, a slippery concept that can lead a central bank astray. Indeed, Mr. Powell sowed confusion during the summer by suggesting neutral was 2.5%, implying the Fed was almost done tightening, igniting a market rally. Mr. Powell had to beat back those impressions, explaining neutral is 2.5% only when inflation is 2%. In fact, he puts underlying inflation at around 4.5%, implying the neutral fed-funds rate could be 5% and rates might have to go even higher.

The problem with such a rule is that inflation responds with long lags behind monetary policy. Unanchored by neutral, the Fed might lift rates to the stratosphere, raising unemployment unnecessarily. The Federal Reserve Bank of Cleveland, using its own models, estimates a first-difference rule would prescribe interest rates of 22% in a year’s time.

Fed officials almost certainly don’t see that as their strategy. Yet for now, they want the public to think they are so committed to 2% inflation that they will risk tightening too much and cause a recession. If the public expects inflation to fall, it is more likely that actual inflation will, too.

At some point, the Fed will appear to change its rule again, and economic weakness, unemployment and the neutral rate will again matter for interest-rate decisions. The challenge for markets is figuring out when.

Write to Greg Ip at [email protected]