Janet’s Choice: Are Rule Based Monetary Policies Still Relevant?

Janet Yellen has increasingly switched her tone of late and is appearing to be far more hawkish on setting short-term interest rates than she had in the past. She has recently suggested that monetary policy was becoming far too accommodative. In reaction, traders are now pricing in about an 80% chance that the Fed will raise interest rates at its’ June meeting.

Central banks generally target short-term interest rates in setting monetary policy. In the United States, the Fed Funds rate is a managed rate that reflects the interest rate at which banks lend each other money overnight. Following the onset of the Great Recession, then Fed Chairman Ben Bernanke dramatically slashed interest rates to aid the economy. The overnight rate reached a rate of practically zero by February 2009 after starting 2007 at a rate of 5.25%. Currently, the Fed is targeting an overnight rate of between 0.50% and 0.75%.

For many years Central bankers took an approach to understanding monetary policy known as the Phillips’ curve, a tool first described by an Australian economist that posits an inverse relationship between the unemployment rate and the rate of inflation. Viewed from this prism, a Central bank makes trade-offs between inflation and unemployment and theoretically one could lower unemployment by creating more inflation. If you were to look at a scatter plot of the rate of inflation and the rate of unemployment throughout the 1960s you very well may come to the same conclusion.

Shortly into the 1970s, though, the situation changed dramatically and the United States experienced “stagflation” – the combination of a high inflation rate and high unemployment rate. In order to explain why this happened a new theory referred to as “rational expectations” gained prominence in many economic circles. Quite simply, it assumes that actors in the economy can be thought of as always acting rationally when taken as an entire group.

How does this solve the Phillip’s curve riddle? Over a short period of time, people largely have consistent expectations about future inflation and they make choices believing that inflation will remain steady at the same rate as the recent past. When a Central Bank lowers interest rates and increases the money supply, business owners presume the incremental demand that’s created is coming from increased aggregate demand in the economy and not simply because prices are rising. In turn, they are likely to hire more employees and expand investments. But, if the credibility of a Central Bank is tarnished and these same actors view the increased demand as inflationary then they will do little more than raise prices.

The view that in the long-term no Phillip’s curve exists (i.e. there is no long-run relationship between employment and prices) gave rise to rule of thumb coined by Stanford economist John Taylor and referred to as the “Taylor rule.” The Taylor rule sets a target interest rate for the Central bank based upon current levels of inflation and economic growth.

Here is the formula:

i = 2% + p + .5*(p-p*) + .5* (g-g*)

Here i is the target Central Bank interest rate, the 2% constant is used as a proxy for the real fed funds interest rate when the economy is in equilibrium, p is the rate of inflation, p* is the target rate of inflation, and g-g* is a measure of how much below natural GDP the economy currently sits.

For many years in the past, Taylor’s rule of thumb gave a very accurate prediction of actual Fed policy. But, it’s deviated substantially since interest rates were cut to zero in the recession. Currently, the Taylor rule predicts a Fed Funds rate that is moving towards 3% – well above where it is now.

Various explanations have been offered for this deviation, including different mechanisms of measuring inflation and the natural level of GDP. But, one key factor has been the unusually low level of interest rates around the world.



When interest rates rise in the United States, dollar-denominated bonds became more attractive to investors and this, in turn, puts upward pressure on the dollar exchange rate. This has undoubtedly happened. The trade-weighted US dollar index moved about 27% higher during a stretch between 2015 and 2016.

In theory, this sharp move in the dollar should be reflected in both the growth and inflation metrics used in the Taylor rule. Some of that reflection, though, may have been delayed for a period of time. Had the Fed been aggressive in raising interest rates, there is a possibility that manufacturing in the United States would have been completely crushed and a problem of deflation could have emerged.

As it stands, it seems sensible to believe what Janet Yellen has been saying, especially in light of potential fiscal stimulus from the Trump Presidency. It seems that interest rates will likely be headed higher in the United States for the foreseeable future.






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