07-01-2025
In January 2021, with PCE inflation at 7.1 percent and the Federal Funds Rate target at 0% to 0.25%, it would be fair to call the Federal Reserve “too late” in waiting until March 2022 to begin to raise its policy rate.
Has the Fed fallen behind the curve again? We can use a Taylor Rule as a guide to the appropriate policy rate. The April Dallas Fed Trimmed Mean PCE inflation is 2.5 percent. Using a coefficient on the inflation gap of 1.5, this would imply 75 basis points of tightening. The May unemployment rate was 4.2 percent. The CBO’s current estimate of the natural rate of unemployment is 4.5 percent. Using a coefficient of 0.5 on the unemployment gap, this implies an additional 15 basis points of tightening. Combining, this implies that the policy rate should be 90 basis points above the neutral nominal long-run policy rate (r* plus 2 percent).
At the June FOMC meeting, members and participants provided their latest estimates of the long-run Federal Funds rate in the Survey of Economic Projections (SEP). Assuming in the long run that the inflation and unemployment gaps are zero, we can take these as estimates of the neutral nominal long-run policy rate. While the range of these estimates is still wide with values going from 2.5 to 3.9 percent, the 75th percentile was 3.5 percent. Clearly, there is still considerable disagreement within the Committee as to the neutral nominal long-run policy rate.
An important task for the Fed is to better pin down its view of the neutral nominal long-run policy rate. Using a value in setting policy that turns out to be too low risks allowing inflation to reaccelerate. If we use the 75th percentile from the latest SEP instead of the median — so as to err on the high side — adding this to our Taylor Rule would imply a policy rate of 4.4 percent. This compares to the current effective Federal Funds rate of 4.33 percent. This would suggest that the Fed’s policy stance is well-calibrated based on available data. The high level of uncertainty over tariffs and tax policy also suggests that the Fed should be cautious in making any changes to its policy rate until this uncertainty diminishes. Unfortunately, this uncertainty is also making it more difficult for the Fed to update and narrow their range of estimates of r*.
While the Fed was “too late” in 2021, right now it’s “too early” to be “too late.”
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. He regularly contributes insightful posts about financial markets to Daniels Insights.
