MNI INTERVIEW: Policy Formulas Call for 2 Fed Hikes This Year

By Jean Yung

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

rules calls for two U.S. interest rate increases this year, in stark contrast to

the Federal Reserve's latest projection of no moves and highlighting the

complexity of Fed data dependence, Cleveland Fed economist Ed Knotek said in an

interview.

     Seven policy formulas including two versions of the well-known Taylor rule

recommend a median fed funds rate of 2.95% by the end of the year and 3.05% by

the end of 2020, according to the Cleveland Fed analysis, using data and

forecasts as of March 22. The effective fed funds rate currently trades around

2.41%, and futures markets are pricing in an 80% chance of a rate cut by

December.

     "Most of these rules are saying the economy is in a pretty good place,"

Knotek said. The U.S. unemployment rate is below the natural rate, putting

upward pressure on the fed funds rate, while core inflation is running close to

2% and is therefore a neutral factor. "Because of that, the rules are projecting

the funds rate should be moving up."

     Simple policy rules tend to be focused on hard data and typically contain

an activity measure and an inflation measure. But they also "omit a lot of

important real world considerations that might be relevant for policymakers,

like the balance of risks and things coming online in the future," Knotek said.

     If one believes risks are weighed one way or the other, "it might cause you

to tilt your policy path one way or another," he said.

     As for financial markets, investors are often looking at a different set of

indicators than those on the real economy. None of the policy rules consider

long term rates or the shape of the yield curve, for example. Yield curves

currently indicate a one-in-three chance probability of a recession a year from

now, compared to just 4% at the start of 2018, another Cleveland Fed economist,

Joe Haubrich, told MNI in an interview.

     Current rules-based recommendations for the policy path are notably lower

compared to a quarter ago. The median recommended rate by year-end fell by 41

basis points as projections for inflation are generally lower and for the

unemployment rate, higher, Knotek said.

     --DATA DEPENDENCE

     Fed Governor Randy Quarles, a Trump administration nominee, and some

Republican lawmakers have argued the Fed should hew closer to policy formulas in

a bid to be more predictable and accountable. Researchers have also found that

policy rules can generate good economic outcomes, Knotek said.

     The Fed routinely consults a range of policy rules ahead of each meeting.

But "the complexity and evolving nature of the economy at the current juncture

argue for the consideration of a wide range of indicators in assessing the state

of that economy," Quarles said in a speech last week.

     "Communicating a data-dependent policy framework can be challenging,

especially if we do not want to appear to be overly discretionary. It would

probably be clearest if we defined what data we are dependent on and how we

depended on those data -- that is to say, if we adopted a monetary policy rule."

Quarles said.

     "Strict rules, however -- to achieve their valuable heuristic benefit --

are as much about ignoring some data as they are about paying attention to other

specific data."

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

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