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Guest contribution: “Federal Funds Rate: FOMC Forecasts, Policy Rule Prescriptions, and Futures Market Probabilities for the June 2024 Meeting”

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Today we have an article written by a guest contributor. David Papell and Ruxandra Prodan-BoulleProfessor of Economics at the University of Houston and Lecturer in Economics at Stanford University.

The Federal Open Market Committee (FOMC) will maintain the target range for the federal funds rate (FFR) at 5.25% to 5.5% at its June 2024 meeting. Economic forecast summary The SEP forecast a 1.25% rate cut by the end of 2024, with the FFR in the range of 5.0% to 5.25%. Futures markets are CME FedWatch Tools Following the meeting, the FOMC projected two rate cuts to the FFR in the 4.75% to 5.0% range by the end of 2024. Comparing the SEP projections to the provisions of the inertia policy rule, which allows the FOMC to smooth out interest rate increases as inflation rises, the FOMC moved from “on track” in March to “higher rates for longer” in June.

It is widely accepted that the Fed’s failure to raise interest rates as inflation rose in 2021 caused it to “fall behind the curve,” forcing it to “catch up” in 2022. But “falling behind the curve” is meaningless without a measure of “being on the curve.” In our paper,Policy rules and future guidance after the COVID-19 recession” compares policy rule prescriptions with the actual and FOMC forecasts of the FFR using data from the SEP from September 2020 to December 2023. This provides a precise definition of “lagging the curve” as the difference between the FFR prescribed in the policy rule and the actual or forecast FFR. In this article, we analyze four policy rules related to the future path of the FFR, update policy rule prescriptions through the June 2024 SEP, and include futures market forecasts.

of Taylor (1993) The unemployment gap rules are:

where is the prescribed level of the short-term federal funds rate, is the inflation rate, is the inflation target level of 2%, is the long-run unemployment rate of 4%, is the current unemployment rate, and is the current neutral real interest rate of 0.5% from the SEP.

Yellen (2012) We analyze a balanced approach rule in which the coefficient on the inflation gap is 0.5 but the coefficient on the unemployment gap is raised to 2.0.

The balanced approach rule received significant attention after the Great Recession and has become the standard policy rule used by the Fed.

These rules are non-inertial because the FFR is fully adjusted each time the target FFR changes. This is inconsistent with the FOMC’s practice of smoothing interest rate increases when inflation rises. We prescribe an inertial version based on the following rules: Clarida, Galli, and Gertler (1999),

where is the degree of inertia and is the target level of the federal funds rate as specified in equations (1) and (2). Bernanke, Kiley, and Roberts (2019)is equal to the rate prescribed by the rule if that rate is positive, and is 0 if the rate prescribed is negative.

Figure 1 shows the midpoints of the FFR target range from September 2020 to June 2024 and the FFRs from September 2024 to December 2026 projected from the June 2024 SEP. Figure 1 also shows the policy rule prescriptions. From September 2020 to June 2024, we use real-time inflation and unemployment data available at the time of the FOMC meeting. From September 2024 to December 2026, we use inflation and unemployment projections from the June 2024 SEP. The difference in prescribed FFRs between the inertia and non-inertia rules is much larger than the difference between the Taylor rule and the balanced approach rule.

Panel A reports policy rule prescriptions for the non-inertia Taylor rule and the balanced approach rule. These are much higher than the 2022 and 2023 FFRs and are inconsistent with the FOMC’s practice of smoothing interest rate increases when inflation rises. In contrast, the policy rule prescriptions for 2024–2026 from the June 2024 SEP are consistently lower than the FFR projections. The inertia rule in Panel B prescribes a much smoother path for interest rate increases from September 2021 to September 2023 than the one adopted by the FOMC. If the Fed had followed the inertia Taylor rule or the balanced approach rule rather than the FOMC’s forward guidance, it could have avoided the pattern of going off the curve, reversing direction, and getting back on track that characterized Fed policy in 2021 and 2022.

Going forward, the policy rule prescription for the June 2024 SEP is below the FFR projection through September 2025 and closer to the FFR projection through December 2026. The current FFR and projected FFR are broadly consistent with the inertia policy rule prescription, but the gap in 2024 is larger than in the March SEP because the FOMC projected three ¼% rate cuts in March and one ¼% rate cut in June. The results for the March 2024 SEP in this paragraph and the next two paragraphs are presented in an Econbrowser post.

Figure 2 shows the median forecasts from the futures market listed on the CME FedWatch tool from the June 2024 FOMC meeting through the end of the CME forecast horizon in September 2025. The futures market forecasts are a quarter of a percent below the FOMC forecast, but they converge at the end. This is because the futures market is forecasting two rate cuts while the FOMC is forecasting one rate cut in 2014. The pattern of futures market forecasts falling short of the FOMC forecast is consistent with December 2023, but not with March 2024, when the forecasts and forecasts matched.

We add to this discussion by including prescriptions from policy rules. Figure 2 shows that for both the Taylor rule and the balanced approach rule, prescriptions from the inertia policy rule from June 2024 to December 2025 are generally below both the CME and FOMC forecasts, but are closer to the CME forecasts than the FOMC forecasts. Moreover, the difference between the inertia policy rule prescriptions and the CME forecasts widens between March and June 2024. Prescriptions from both non-inertia policy rules are significantly below the FOMC and CME forecasts for the same period. The comparison of futures market forecasts and policy rule prescriptions depends more on the choice between the inertia rule and the non-inertia rule than on the choice between the Taylor rule and the balanced approach rule.

This post David Papell and Ruxandra Prodan-Boulle.

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