The Federal Reserve raised interest rates once again, adding to the sharpest series of hikes since the 1980s. So far, the Fed has increased rates by three points this year and Chair Jerome Powell says there’s more to come.—pbs.org
Fed officials signaled the intention of continuing to hike until the funds level hits a “terminal rate,” or end point of 4.6% in 2023.—cnbc.com
What is the interest rate that the Fed raises and lowers to conduct its monetary policy?
The Federal Reserve’s (Fed’s) monetary policy instrument is the federal funds rate, which is the interest rate on loans of reserves among banks. These interbank loans are made in the federal funds market.
How does a rise in the federal funds rate influence the economy?
When the Fed raises the federal funds rate, other short-term interest rates rise and the exchange rate of the U.S. dollar with other currencies rises on the same day. A few weeks through a few months later, the quantity of money and supply of loanable funds decrease, which raises long-term real interest rates. Up to a year later, consumption expenditure, investment, and net exports decrease, which lowers aggregate demand. Eventually, the rise in the federal funds rate has had ripple effects that slow the growth rate of real GDP and up to about two years later, lower the inflation rate. These time lags in the effects of a rise in the federal funds rate are variable.
How does the Fed make its interest rate decision?
The Fed pursues a discretionary monetary policy. To make its interest rate decision, the Federal Open Market Committee (FOMC)—seven members of the Fed’s Board of Governors and five presidents of regional Federal Reserve Banks—gathers and analyzes a vast amount of data and comes to a judgment about the level of the federal funds rate that will best achieve its goal of 2 percent inflation and full employment.
What is the alternative to discretionary monetary policy?
The alternative to discretionary monetary policy is a rule-based monetary policy, which sets the federal funds rate by a fixed rule. The best-known rule is one proposed by John Taylor, an economist at Stanford University.
The Taylor Rule is a formula that sets the federal funds rate at the long-term average real rate, plus the inflation rate, plus one-half of the gap between the inflation rate and its target, plus one-half of the output gap. With r the federal funds rate, p the inflation rate, y the output gap, the long-term average real rate 2 percent, and the target inflation rate also 2 percent, the rule is:
r = 2 + p + 0.5(p – 2) + 0.5y,
which simplifies to
r = 1 + 1.5p + 0.5y.
In words, the Taylor Rule sets the federal funds rate at 1 percent plus 1.5 times the inflation rate plus 0.5 times the output gap.
The weight on inflation being greater than 1 satisfies the Taylor Principle, which states that if the inflation rate rises by k percent, the federal funds rate must be raised by more than k percent.
Supporters of a rule-based policy say it is more predictable than discretionary policy and it reduces uncertainty about future policy decisions. Less uncertainty boosts business investment and economic growth. And less uncertainty about future inflation promotes the efficient working of capital markets and labor markets where agreements are based on long-term contracts.
How high does the Taylor Rule set the federal funds rate?
In mid-2022, the Taylor Rule sets the federal funds rate at 9.4 percent, a much higher level than the current 3.25 percent.
To satisfy the Taylor Principle, the federal funds rate will at least need to exceed the inflation rate, which in August 2022 was running at 6.3 percent (measured as the year-on-year percentage change in the Personal Consumption Expenditures Excluding Food and Energy Chain-Type Price Index).
How high will the federal funds rate go?
No one, not even the FOMC members, knows at what level or when the federal funds rate will reach its peak. The belief noted in the news clip is that the federal funds rate will keep rising until it reaches 4.6% in 2023.
Figure 1 shows the forecasts of 44 economists in mid-September.
Two-thirds of the economists surveyed believe the federal funds rate will peak between 4 percent and 5 percent, in agreement with the news clip. No respondent said it will exceed 7 percent per year, and only 2 percent see a rate above 6 percent per year.
Are these forecasts in line with historical experience?
In 1975, inflation in the United States exceeded 10 percent per year. In 1980, inflation was close to 10 percent again. In the 1970s inflation, the Fed raised the federal funds rate to 7.3 percent. The inflation rate was lowered, but only for a few years. In the 1980s inflation, the federal funds rate soared and peaked at 18.9 percent per year. The result was a swift and long-lasting fall in inflation, but at the cost of recession.
Figure 2 shows the history of inflation and the federal funds rate since 1962.
Notice in Figure 2 that the federal funds rate has usually exceeded the inflation rate. The inflation rate exceeded the federal funds rate only in the mid-1970s, the early 2000s, and since 2008. In 2022, the gap between the inflation rate and the interest rate is unusually large.
Two histories might repeat: the 1970s, with a rise in the federal funds rate that falls short of the inflation rate, or the 1980s, with a very large interest rate rise that exceeds the inflation rate.
A rerun of the 1970s seems more likely. But don’t forget what followed in the 1980s! The experience of the 1970s and 1980s says that if inflation is going to be lowered and remain low, the federal funds rate is going to peak at a higher level than most economists are currently forecasting.
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