Does Nonfarm Payroll Growth Improve the Taylor Rule?
There has been a lot of interest in financial circles in finding a guidepost or rule of thumb that reflects how monetary policymakers decide how to set interest rates. Given that the federal funds rate—the short-term interest rate set by the Federal Open Market Committee (FOMC)—has been at zero for a while, such a rule may not seem useful today. But presumably it will be once the rate is above zero, and it is interesting to see what the rule suggests about when the rate will increase. Some versions of the rule predict an earlier increase than the FOMC’s current projections, and we explain why this would be so.
There are many variations of this so-called “Taylor rule” out there, but one variation that is commonly used and is consistent with the FOMC’s dual mandate of price stability and maximum employment is one that has the Federal Reserve responding positively to increases in core inflation above its target and negatively to increases in unemployment above the long-run normal level of unemployment. This version of the rule is usually expanded to include the previous quarter’s federal funds rate to reflect the likelihood that the FOMC adjusts the fed funds rate gradually toward its desired target.
When this version of the rule is estimated with data from 1987-2008, it seems at first glance to do a decent job of tracking the actual federal funds rate. But looks can be deceiving. It misses the actual funds rate by an average of 34 basis points. That is not much better than a simple, naïve rule that assumes today’s funds rate is merely yesterday’s funds rate—the average absolute miss for this simple rule and the same data is 37 basis points. In the end, the common version of the Taylor rule basically just predicts that the funds rate will be where it was last quarter. This implies there can be significant misses with it.
Zooming in over the time period 1992-2000, we can see clearly an example of such a miss. In mid-1994, for example, the miss was quite large—about 91 basis points.
In the end, the common version of the Taylor rule basically just predicts that the funds rate will be where it was last quarter. That is, the Taylor rule is always a step behind the actual funds rate. We can modify the rule to account for this fact by including a leading indicator of the unemployment rate. One decent candidate is nonfarm payroll growth.
To say nonfarm payroll growth is a leading indicator is to say nonfarm payroll employment typically rises before the unemployment rate drops. In fact, increases in payroll growth appear to lead to a fall in unemployment about two quarters later. For example, the unemployment rate reached its nadir in 2006:Q4, three quarters after the peak in payroll growth (2006:Q2).
When nonfarm payroll growth is added to the Taylor rule above, the new rule does a much better job of capturing the movements of the actual fed funds rate. The predicted path of the rate is still a little behind the actual funds rate, but it is much better than it was with just the unemployment gap. In fact, the modified rule enhances the “fit” substantially. Before, the average absolute miss was 34 basis points; now it is 22 basis points. This is a sizable improvement, given that it eliminates more than one-third of the original miss.
It is worth noting that there are time periods, such as 2007-2008 (going into the financial crisis), when both rules display large misses. Such periods illustrate that Fed does not mechanically follow any rule. Instead, especially when unusual developments are taking place or are anticipated, it will deviate from its usual behavior.
For comparison purposes, the chart below zooms into the same 1992-2000 period discussed earlier. Focusing on the 1994-1996 time period, it is quite obvious that the Taylor rule with payroll growth and the unemployment gap does substantially better than the rule with only the unemployment gap. In fact, the problem of the Taylor rule being a step behind the actual funds rate is largely eliminated. A review of FOMC minutes around this time period shows clearly that the Committee was closely monitoring labor markets, and FOMC participants explicitly mentioned nonfarm payroll employment and the unemployment rate as their rationale for policy moves. Furthermore, the strong gains posted in payroll employment throughout this period coincided with fed funds rate increases.
Given that this new Taylor rule does a better job of estimating past values of the federal funds rate, the next step naturally is to use it to project the future path of the federal funds rate. To produce the future federal funds rate path, we use the most recent economic projections of FOMC participants (December 2012), which are reported in the Survey of Economic Projections (SEP). Specifically, we use their projections for the core personal consumption expenditures price index (for inflation), the unemployment rate, and the long-run normal level of unemployment. Since the SEP does not include a forecast for nonfarm payroll growth, we use the forecast for it from Macroeconomic Advisors (MA), a private forecasting firm.
We compare the federal funds rate path and the liftoff dates implied by our modified Taylor rule with median fed funds rate projections from the December 2012 SEP. We define liftoff as the date at which the projected fed funds rate exceeds 50 basis points.
According to the fed funds rate path estimated with our modified Taylor rule, the first fed funds rate increase would occur in the third quarter of 2014, about four quarters earlier than the median fed funds rate projection from the December 2012 SEP.
The quite different exit dates at first glance seem surprising. But they could be explained two different ways. For one, some other Taylor-type policy rules imply a later liftoff than does our adjusted policy rule. With these rules, liftoff is closer to the date suggested by the FOMC’s December projections. Alternatively, one way the Committee can stimulate the economy today is by promising that the funds rate will stay at zero longer than it would typically, where “typically” would be the Taylor rule projection. By promising to keep rates low longer, they can lower long-term interest rates and stimulate the economy. The recent FOMC meeting statement (January 2013) reaffirms this point: “To support continued progress toward maximum employment and price stability, the Committee expects that a highly accommodative stance of monetary policy will remain appropriate for a considerable time after the asset purchase program ends and the economic recovery strengthens.” Furthermore, according to a recent speech by FOMC Governor Janet Yellen, keeping interest rates lower than the prescriptions of the well-known Taylor rule or its variants would be optimal in terms of economic outcomes.