taylor16_OLIVIER DOULIERYAFP via Getty Images_fed reserve flag OLIVIER DOULIERYAFP via Getty Images

The Fed’s State of Exception

Despite the recent surge of inflation in the United States, the Federal Reserve is keeping the federal funds rate in a range far below what its own monetary-policy rules would prescribe. But since history shows that this deviation cannot last indefinitely, it would be better to normalize sooner rather than later.

STANFORD – Over the past few months, there has been a growing chorus of economic observers voicing concerns about the increase of inflation in the United States. Much of the commentary (including my own) has focused on the US Federal Reserve’s apparent continuation of easy monetary policy in the face of rising prices. Despite a sharp increase in the rate of money growth, the central bank is still engaged in a large-scale asset-purchase program (to the tune of $120 billion per month), and it has kept the federal funds rate in the range of 0.05-0.1%.

That rate is exceptionally low compared to similar periods in recent history. To understand why it is exceptional, one need look no further than the Fed’s own July 9, 2021, Monetary Policy Report, which includes long-studied policy rules that would prescribe a policy rate higher than the current actual rate. One of these is the “Taylor rule,” which holds that the Fed should set its target federal funds rate according to the gap between actual and targeted inflation.

The Taylor rule, expressed as a straightforward equation, has worked well when it has been followed over the years. If you plug in the current inflation rate over the past four quarters (about 4%), the gap between GDP and its potential for the second quarter of 2021 (about -2%), a target inflation rate of 2%, and a so-called equilibrium interest rate of 1%, you get a desired federal funds rate of 5%.

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