10-22-2024
Now that the Fed has gotten up out of its chair and moved onto the dance floor, it needs to think about the cadence of its next policy moves. In my last post, I discussed how the Taylor rule provides guidance to setting monetary policy. It can also be useful for thinking about the pace of adjustments to the Fed’s policy stance.
A challenge in using the Taylor rule in practice is uncertainty. Each of the three components of the Taylor rule is estimated and not observed — the underlying rate of inflation used in the inflation gap, the natural rate of unemployment used in the unemployment gap, and the natural rate of interest used to determine the neutral policy rate. Of the three, the greatest uncertainty currently is over the natural rate of interest and therefore the neutral policy rate.
This uncertainty over the neutral policy rate implies that the Fed is trying to achieve a soft landing when there is a dense fog covering the runway and its altimeter is acting erratic. Under these circumstances, a pilot would approach the landing by bringing the plane near to where the runway possibly might be and then cut the plane’s airspeed and rate of descent in order to “feel” the final way into a landing.
The Fed updated the forecasts of its views on the neutral policy rate at its September meeting. As I discussed in an earlier post, the range across the middle half of the committee’s estimates on the neutral policy rate ranges from 2.75 percent to 3.37 percent. If we use the upper end of this range as a starting point, then this would imply that when both the inflation and unemployment gaps are closed, the Fed should steer its policy rate to around 3.37 percent — or, in the range of 3.25 to 3.5 percent.
With the current estimate of the inflation and unemployment gaps, this would imply a policy rate of 4.25 to 4.5. This suggests that the Fed could make another 50-basis point reduction in its policy rate at its November meeting. They could then continue to reduce the policy rate as the inflation gap closes following the Taylor principle. This would allow time for the Fed to observe the economy and learn about the likely level of the neutral policy rate. Any further policy rate reductions below 3.25 to 3.5 percent that are based on a lower updated assessment of the neutral policy rate could be spread over time as the Fed gains more confidence in their assessment. That is, the Fed can feel the final way to a neutral policy.
Now that the Fed has moved onto the dance floor, it needs to think about the cadence of its next policy moves. In doing so, it might want to keep in mind the Salsa beat — fast, fast, slow.
Joseph Tracy is a Distinguished Fellow at Purdue University’s Daniels School of Business and a nonresident senior fellow at the American Enterprise Institute. Previously he was executive vice president and senior advisor to the president at the Federal Reserve Bank of Dallas.
