January 14, 2022 | 13:38
Too-Loose Policy and the Myths that Got Us Here
Taylor Says: The Fed Is Far Too Lax
“The economy no longer needs or wants the very accommodative policies we have had in place.”—Fed Chair Powell, January 11, 2022
How loose is U.S. monetary policy? Are the levers calibrated just right to sustain maximum employment and price stability; or, are they set too loose, risking the need for corrective action that could send the economy into a tailspin? One simple way to help answer this question is with the Taylor rule, named after the Stanford University economist who created it in 1993 . In its simplest form, the rule prescribes an optimal policy rate to achieve full employment and price stability. If inflation is above target or the jobless rate too low, the rule recommends raising the policy rate, and vice versa. When full employment and price stability are reached, the rule suggests keeping the policy rate at a neutral level consistent with both goals.
The Taylor rule has gone through many iterations since inception. We use a standard version adopted by the Atlanta Fed . It recommends a policy rate based on: the deviation of the current policy rate from neutral; the gap between current inflation (the year-over-year change in the core PCE measure) and target inflation; and the difference between the actual unemployment rate and its sustainable rate (we use the median FOMC member’s estimate of 4.0% for the current period and an estimate by the Congressional Budget Office for the historical period). For the neutral policy rate, i.e., the rate consistent with full employment and price stability, we use the median FOMC member’s estimate of 2.5% (as of December 2021) for the current period. Subtracting the inflation target implies a neutral real policy rate of 0.5% today. The neutral real policy rate has likely fallen in recent decades due to lower potential growth, excess global savings, and higher debt levels, and the downward trend is confirmed by a decline in the ten-year rolling average real policy rate since the 1990s. This is the series used for the neutral real policy rate in our Taylor rule calculation over history.
Chart 1 plots the actual fed funds rate against the recommended rate back to 1970. Note three things: First, the Taylor rule broadly tracks actual policy, albeit with periodic wide gaps. Second, the prescribed rate was negative after the 2008 financial crisis and the 2020 pandemic shutdown, warranting quantitative easing in lieu of negative policy rates to address high unemployment and low inflation. Third, and most relevant to our discussion, the rule suggests the Fed’s policy rate should be almost 6% today. (By comparison, the rule suggests the Bank of Canada’s policy rate should be around 2½%, a far smaller deviation from actual policy.) One caveat is that current U.S. core inflation of 4.7% partly reflects low prices a year ago. But even using the two-year annualized rate of 3.0% to filter out so-called base effects suggests the policy rate should be close to 4%. Moreover, given expected increases in wages and rents, the yearly rate could be the better proxy of trend inflation, as suggested by shorter-term price movements.
In either case, with the actual funds rate close to zero, the current policy stance is the laxest since the mid-1970s. This was the last time the recommended policy rate deviated from the actual rate by more than two standard deviations on the high side. In fact, policy is likely even looser today since a doubling of the Fed’s balance sheet over two years has applied further downward pressure on longer-term borrowing costs.
Chart 2 hints at the possible cost of running a too-loose policy. Five of the last seven U.S. economic downturns (in 1974, 1980, 1981, 1990, and 2008) were preceded by an actual policy rate that was well below the recommended rate, albeit with a lengthy lag. Prior to the downturn, inflation pressures and financial imbalances emerged to eventually derail the expansion. In most cases, the Fed needed to over-tighten policy to remedy the situation, resulting in a downturn. Ominously, the mid-1970s was also plagued by both double-digit inflation and a recession.
Of course, as its name implies, the Taylor rule isn’t a hard-and-fast law. It leaves no room for the many nuances that decision makers need to consider when setting policy, such as a pandemic. Despite the adverse effect on supply and inflation, COVID-19’s severe impact on some sectors and uncertain path likely warrant an easier policy stance than a simple rule suggests. For this reason, the Taylor rule is often only one of many inputs used to inform central bank judgement.
Still, at the very least, the Taylor rule shouts that the Fed has put too much rum in the punchbowl. Ultra-loose policy has fed excess demand, thereby contributing to supply shortages and inflation pressures. (For more on this topic, see Robert Kavcic’s article, “Extraordinary Popular Delusions and the Madness of Policymakers” on page 10.) It may also have fuelled excess risk taking and asset price imbalances that threaten to come to the fore. Most disturbing, by trying to juggle several goals—price stability, maximum jobs, inclusive recovery—the Fed now risks fumbling all three.
Extraordinary Popular Delusions and the Madness of Policy
Policymakers reacted to the pandemic with a swift and aggressive response, which was appropriate early on given the unknowns facing the economy. But, as the pandemic progressed it became clear that policy was left far too stimulative, for far too long, resulting in inflation pressure and some excesses in asset prices. That has been partly the result of some key misinterpretations, which we highlight below.
Belief: There is considerable excess capacity in the economy. Reality: There’s next to none.
The Bank of Canada’s latest policy statement argued that, “in view of ongoing excess capacity, the economy continues to require considerable monetary policy support”. Meantime, the Federal Reserve has maintained interest rates at the lower bound “until labor market conditions have reached levels consistent with the Committee’s assessments of maximum employment”. In both cases, official data and feedback from the business community have been suggesting full capacity for some time. In Canada, the share of firms with difficulty meeting demand has never been higher (Chart 1). In the U.S., record job vacancies highlight a labour market that is much tighter than policymakers have given it credit for. Part of the misinterpretation likely comes from the fact a sliver of the economy has experienced an extreme hit, somewhat masking broad strength almost everywhere else. At the same time, the pandemic-induced negative supply shock has likely held back potential output, thereby closing output gaps faster than believed.
Belief: Supply constraints are driving inflation. Reality: Spending (demand) has surged.
The economy has faced a negative supply shock, especially as labour and production are held back by the pandemic. But, a historic surge in household spending on goods would clog supply chains in even the best of times. In the U.S., nominal spending on goods has surged more than 20% above pre-COVID levels (Chart 2), or a mind-boggling $800 bln in excess above the baseline (that’s not spending, that’s extra spending). The supply chain never stood a chance to respond to this surge. A rapid job recovery in most sectors, cheap credit and fiscal transfers have all aided the surge. And, it hasn’t simply come as a substitute for services spending, as the latter is now back to pre-COVID levels.
Belief: We need more houses. Reality: It’s demand.
While there is truth to longer-term supply issues in Canada, development hurdles and intensification crowding out single-family homes, the acute issue today is heated demand. Home sales in Canada surged more than 50% above pre-COVID norms at one point in 2021 (Chart 3), vapourizing what has been a normal run-rate of new listings. At the margin, multiple-property owners (e.g., investors) have led the increase, accounting for the largest share of transaction volume in 2021, according to Teranet registry data. Survey data suggest expectations of home price growth are getting engrained. Now, raise your hand if you saw any houses in your area change hands three times in 2021—hand goes up.
Belief: We need ongoing fiscal support. Reality: There’s been more than enough.
Highly-targeted measures aimed at sectors forced to curb operations still make sense. But, on a large scale, federal government support has gone beyond replacing lost income due to the pandemic. In Canada, household disposable income has surged well above the pre-COVID baseline, as enormous government transfers have more than offset the decline in employment income. The latter is back to baseline, but fiscal support continues to flow. There has been roughly $85 billion in excess government-to-household transfers through 2021Q3 (Chart 4). That’s almost 4% of GDP beyond replacing lost incomes, which has fuelled housing, spending and inflation.
Belief: There’s no risk in risk assets. Reality: They’re about to get tested.
Asset prices of all types have feasted on excessively stimulative monetary policy. This week, the Federal Reserve made it clear that it would draw down its balance sheet earlier and faster than in past cycles which, along with potentially abrupt interest rate hikes, could pose a headwind. Stocks have historically struggled during periods of change in the Fed’s balance sheet trajectory (Chart 5), and valuations in some higher-flying sectors could be stressed by higher interest rates. The investor component of the housing market could also be tested if already cash-flow-negative properties (assuming the standard 20% down) soon face higher mortgage payments. In Canada, the shift into variable-rate mortgages that has fuelled the latest bout of strength will be tapped out soon.