Play by the (Taylor) Rules
The interest rate projections released after the January Federal Open Market Committee (FOMC) meeting were another step toward increased Fed transparency. As described in a previous article, the additional information about FOMC participants’ views on appropriate policy should help shape market participants’ expectations for future policy actions. In the projections, each member of the FOMC described how he or she would conduct interest rate policy, given economic conditions in January and how they expect conditions to develop going forward. However, connecting the dots between the future interest rate policy and the economic data still leaves room for interpretation. Can we ascertain some of the important variables that Committee members are implicitly responding to?
Estimating a Taylor rule can help with the interpretation. The original Taylor rule was created in 1993, and it defined a relationship between the federal funds rate, the rate of inflation, and deviations of economic output from its potential. Because the FOMC has made it clear that its dual mandate dictates that both inflation and unemployment must be considered when conducting monetary policy, we modify the original rule so that the fed funds rate depends on inflation (which we take to be core PCE inflation) and unemployment. Implicit in an unemployment rate is the idea of a gap between the current and the optimal level of employment.
Our version of the rule tracked the actual funds rate fairly closely, until interest rates hit near zero and could not be lowered any further. This suggests that in the past the Committee has used something akin to this rule as a guidepost for monetary policy.
A relevant question now is whether such a rule roughly describes Committee members’ views on appropriate monetary policy going forward. To get at that question, we use the FOMC’s January projections for inflation and unemployment to produce a federal funds rate path into the future. We estimate the funds rate path from the first quarter of 2012 through the second quarter of 2017 in the chart below (Note: this time period is used to match the definition for the longer-run projections, representing five or six years ahead).
Because of the range of projected economic outcomes, we can produce a range of rule-implied federal funds rate paths. These paths, of course, are what the Taylor rule predicts the funds rate would be if FOMC members could set negative interest rates. The bottom of the fan represents the Taylor rule being calculated with the highest projected level of unemployment and the lowest projected rate of core inflation in any given period. (Note: we are implicitly assuming that the Committee member with the highest unemployment projection had the lowest inflation projection. This clearly may not be the case.) Similarly, the top of the fan bakes in the opposite extremes in the projections for those two variables. The darker bands do a similar exercise with the central tendency of the projections, which simply excludes the three highest and three lowest projections for each variable in each year. Finally, the median path is just the midpoint of the central tendency projections.
The value in this exercise is comparing the results from the Taylor rule to the FOMC participants’ interest rate projections. The January FOMC statement, which reflects the Committee’s consensus view, said that “economic conditions are likely to warrant exceptionally low levels of the federal funds rate at least through late 2014.” According to the median path predicted by our unemployment Taylor rule, the first fed funds rate increase would occur in the second quarter of 2014.
We also have the entire histogram to work with, which gives the whole range of participants’ expected first rate increases. The very early end of those projections shows the first possible rate increase in 2012, a date projected by three Committee members. Our unemployment Taylor rule also predicts the earliest rate increase to occur in the fourth quarter of 2012. The timing of the latest exit from near zero interest rates, as projected by FOMC participants, was in 2016. Again, the unemployment Taylor rule predicts the same year.
If we knock off the top and bottom three projections in the histogram, we see that the central tendency range is tighter, centered around 2014, with three participants each on 2013 and 2015. The unemployment Taylor rule does a decent job matching this central tendency. From the fan chart, the bottom of the central tendency predicts a rate increase from the zero bound in the third quarter of 2013, the same year the central tendency in the histogram would imply. If we look at the top of the central tendency, the Taylor rule and the FOMC projections both show an exit beginning in 2015.
|Bottom of range||Bottom of central tendency||Median||Top of central tendency||Top of range|
|The timing of the first rate increase, according to:|
|January 2012 SEP projections||2012||2013||2014||2015||2016|
|Unemployment Taylor rule||2012:Q4||2013:Q3||2014:Q2||2015:Q3||2016:Q1|
Note: The central tendency excludes the three highest and three lowest projections for each variable in each year. The range includes all participants’ projections, from lowest to highest, in that year. The dates in the Summary of Economic Projections (SEP) are only reported as annual numbers, so the quarter in which the rate increases would occur are unknown.
Sources: Federal Reserve Board; January 2012 Summary of Economic Projections (SEP); Bureau of Economic Analysis; Bureau of Labor Statistics; authors’ calculations.
It is important to keep in mind that these are very rough exercises. Obviously no Committee member would literally think that appropriate monetary policy would be to slavishly follow such a rule. There are a myriad of other factors that Committee members would also look at. Nevertheless, this exercise illustrates that such a rule roughly captures many Committee members’ views of appropriate monetary policy.