MNI INTERVIEW: Taylor Rule Supports March Cut -Ex-Fed's Tracy

Monetary rules of thumb suggest the Federal Reserve would be well-placed to begin lowering interest rates in March, especially with global economic weakness and geopolitical conflicts keeping economic activity and inflation in check, former senior adviser to the president at the Dallas Fed Joseph Tracy told MNI.

Assuming the natural rate of unemployment is 4.5% and underlying inflation is running at the Dallas Fed trimmed mean PCE inflation rate of 3.3%, Taylor rule estimates would prescribe a fed funds rate of around 4.85%, Tracy said. It may be slightly higher if both the neutral rate and the natural rate of unemployment are higher than in the past, as many have argued, he said. The current fed funds rate target stands at 5.25%-5.5%.

"This puts a 25 basis point cut on the table for March. If I wanted to take out a little insurance against the geopolitical risks, I would lean toward taking the cut in March rather than waiting," Tracy said.

The policy rules would call for a roughly quarter-point reduction in the fed funds rate for every 20bp fall in the trend inflation rate as the FOMC steers policy rates back to a neutral level of around 2.5%, Tracy said. The tight labor market is contributing just 40bp to the fed funds rate, according to the formulas.

"This is exactly the time the committee wants to be data dependent, and have a benchmark that can be communicated to markets," Tracy said. "It's important to try to keep things simple. The challenge is monetary policy works not just through the federal funds rate but how it affects financial conditions. But if the market misreads the Fed, then we get unnecessary swings in the effective degree of accommodation or restriction."

FRAMEWORK REVIEW

The FOMC's 2020 shift to an "asymmetric" treatment of its employment mandate deserves reconsideration, particularly now that prices have shown they can accelerate in tight labor markets, said Tracy, non-resident senior scholar at the American Enterprise Institute.

The Fed revised its policymaking framework to say it would only react to "shortfalls of employment from its maximum level" and not prevent job creation above a maximum sustainable level. It's set to begin a fresh review of its framework later this year.

"You can imagine lowering the federal funds rate not because inflation is coming down but unemployment ticks up a little bit, say from 3.7% to 3.9%. I would argue that's another reason to trim the fed funds rate," he said. "If we see evidence that the tight labor market is moving back to normal, that should also contribute to normalizing the policy rate."

Another long-run consideration for the Fed is whether the costs of a much larger balance sheet are worth the benefits of using asset purchases as an active tool of monetary policy. By the time the FOMC slows and stop quantitative tightening, its balance sheet will be trillions of dollars larger than before the pandemic and has incurred unprecedent operating losses. That larger footprint in markets suppresses term premia and price discovery, and its mortgage bond purchases arguably affect credit allocation in the economy -- all of which can ultimately hurt the Fed's independence, Tracy argues.

"The bigger question going forward is whether they're going to rethink whether balance sheet activities were helpful or not. Someone needs to do this but it's not necessarily the central bank."