MNI INTERVIEW: Monetary Rules Say Fed No Longer Behind Curve

Simple monetary policy rules suggest the Federal Reserve's interest rate stance will have finally caught up to where it needs to be to rein in inflation after another quarter-point increase in July, former Dallas Fed principal policy adviser Evan Koenig tells MNI.

Koenig, who spent more than three decades at the Dallas Fed, had been critical of the central bank's failure to react quickly to rising inflation in the pandemic era. But with inflation projected to fall toward 3% by the end of the year, a range of policy rules including one developed by Koenig in 2019 now see a fed funds target of 5.25%-5.5% as right in the middle of their prescriptions for appropriate policy rates.

"That’s encouraging, because in a way it suggests Fed policymakers aren’t behaving all that differently than historically, and they’re no longer behind the curve as they were for a considerable time," Koenig said in an interview.

Whether that helps the chances of achieving a growth recession and significant reduction in inflation without a spike in unemployment -- the soft landing sought by Fed Chair Jerome Powell -- Koenig is unconvinced. "Is that the most likely outcome? I remain skeptical," he said.

TAYLOR RULES

A Cleveland Fed analysis of seven simple monetary policy rules would prescribe a benchmark interest rate of 2.80% to 6.99% for the current quarter, with a median of 4.99%. The fed funds rate target is currently set at 5%-5.25% with most FOMC officials penciling in at least two more 25bp hikes this year.

Koenig's version of the Taylor rule, which thinks of the FOMC as choosing the short term rate relative to a long forward rate and responding not to current inflation but near-term inflation expectations, accurately describes the Fed's reaction function in the long expansion following the financial crisis where standard Taylor rules had predicted much higher rates.

That rule shows a 5.25% to 5.5% target range for the fed funds rate would span the range of reasonable estimates, based on various assumptions for the economic outlook.

Koenig cautioned, however, that if inflation does not see the considerable decline expected by the FOMC by the end of the year, the policy rule would suggest a short term rate up to 75 bps higher for each percentage point of higher-than-expected inflation.

SOFT LANDING

The big mystery for the U.S. economy now is where that projected decline in inflation in the next year will come from, if not from a higher unemployment rate, Koenig said. A decline in the vacancy rate this year suggests the labor market has loosened a bit even with unemployment holding steady near historically low levels.

Prominent economists disagree over whether the vacancy rate can normalize without a jump in the jobless rate.

"You have to wonder, is that realistic?" Koenig said. "The fact that the vacancy rate come down as much as it has without a rise in the unemployment rate has left people more willing to think about the possibility that this could continue for a while, but they don’t regard it as the most likely outcome."

Either way, it would call for "either a higher policy path or one that stays restrictive for longer," he said.

NOMINAL SPENDING TOO HOT

At present, nominal spending growth is still too hot and consistent with an underlying inflation rate of over 4%, Koenig said.

Nominal personal consumption expenditure growth through May is just over 6%, with a six month annualized rate of 6.1%.

Trimmed mean PCE inflation through May is 4.6% over the year and 4.3% on a six-month annualized basis. The latest CPI report for June shows core CPI remains elevated at 4.8% or 4.6% on a six-month annualized rate. Subtract roughly half a percentage point to translate that into the Fed's preferred PCE inflation measure and that still leaves underlying inflation above 4%, Koenig said.

"Despite all the positive spin from the CPI report this week, there’s not much to go on," he said.