MNI EXCLUSIVE: Mon Pol Rules Call For 1 More Fed Hike By Dec

--Median Outcome of 7 Simple Policy Rules Calls for Gradual Rise in FFR

--Choice of Inputs, Forecasts Lead to Very Different Results, Fed Economist

Tells MNI

--Trump's Fed Board Nominee Quarles Has Called for Rules to Guide Policy 

By Jean Yung

     WASHINGTON (MNI) - The median policy recommendation of a survey of monetary

policy rules calls for a third interest rate increase this year and three in

2018, matching the Federal Reserve's latest forecast, but individual rules

produce a wide range of policy results that are also sensitive to the input data

used, a Federal Reserve economist told MNI in an exclusive interview. 

     The analysis highlights some of the issues that will need to be given

serious consideration if Republican lawmakers win out in their effort to hold

the Fed to a formula-based system. President Trump's first nominee to the Fed

Board of Governors, Randal Quarles, has spoken in favor of policy rules, as have

others reportedly under consideration. 

     Edward Knotek, senior vice president and head of the macroeconomic

forecasting group at the Federal Reserve Bank of Cleveland, tabulated the

outcomes of seven simple policy formulas using three sets of economic forecasts

and found the median recommended fed funds rate by the end of the year to be

1.47%, roughly equivalent to one more 25 basis point hike.

     By the end of 2018, the benchmark rate should be 2.2%, according to the

formulas -- close to the Fed's June forecast of 2.1%. Policymakers are due to

update their forecasts in two weeks. The effective fed funds rate currently sits

at around 1.16%, and futures markets are only pricing in a 30% chance of any

hike at all by December.

     "We're looking across a number of rules, a number of forecasts, so

presumably the median is going to be relatively insensitive to outliers," Knotek

said. "The median does suggest a gradual upward sloping path for the fed funds

rate based on these rules and these forecasts." 

     However, the different rules and even the same rule using different sets of

economic forecasts lead to wide-ranging results. 

     A version of the well-known Taylor rule, for instance, using a neutral real

rate of interest or r-star of 1%, recommends an interest rate of 2.4% by

year-end 2017. The less-known first-difference rule, which considers only

inflation and unemployment, recommends a policy target of just 0.9%. 

     "When you talk about policy rules there's usually a sense that there's a

single rule, but the point of this exercise is really to show that there are

many different rules and different variables that are somewhat similar with

little differences, and how those little differences affect what policy rate

comes out of the rule," Knotek said. "The maximums and minimums are fairly

different in many cases." 

     Which variables one puts into a policy rule matters. Depending on whether

one uses core or headline inflation, forecasts versus lagged variables, an

unobservable concept like r-star, or take into account policy inertia -- the

concept that it takes time to adjust policy to a target rate -- can give you

vastly different prescriptions for the funds rate. 

     "And that's just a small sliver of the universe of information that you

might want to take into account," Knotek said. 

     The seven rules examined by the Cleveland Fed are similar to ones used by

Fed staff economists to prepare Federal Open Market Committee members before

their policy meetings. Officials have argued that while the rules offer useful

benchmarks, picking one and setting it on autopilot could lead to perverse

outcomes for the U.S. economy. 

     However, Republican congressmen say the Fed has too much discretion and its

policy had contributed to market instability. Sticking to a rule will make

policy more predictable. they say.

     But Knotek cautions that there are as many cons as there are pros to

relying on formulas.  

     "One of the beautiful features of a simple policy rule is it lets you focus

on two or three key variables, but the shortcoming is precisely that it makes

you focus on only two or three variables when the real world is a very complex

place," Knotek said. 

--MNI Washington Bureau; +1 202-371-2121; email: jean.yung@marketnews.com

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