Guest Contribution: “The Fed Fell Behind the Curve by Not Following its Own Policy Rules”

Today, we present a guest post written by David Papell and Ruxandra Prodan, Professor and Instructional Associate Professor of Economics at the University of Houston.


The Federal Open Market Committee (FOMC or Committee) raised the target range for the federal funds rate (FFR) by 3/4 percent (75 basis points) from 0.75 – 1.0 percent to 1.5 – 1.75 percent at its June 2022 meeting and projected a range between 3.25 and 3.5 percent by the end of 2022. While the statement “anticipates that ongoing increases in the target range will be appropriate,” Chair Powell’s press conference, the minutes, subsequent remarks by FOMC members and the most recent inflation data make it clear that another 75 or even 100 basis point increase in July is virtually certain. This followed a 25 basis point increase from the effective lower bound (ELB) of 0.0 – 0.25 percent in its March meeting and a 50 basis point increase in its May meeting.


While there is widespread agreement that the Fed fell “behind the curve” by not raising rates quickly enough when inflation rose in 2021, there are two very different leading explanations. The “we didn’t know” explanation, advanced by Fed Chair Jerome Powell and other members of the FOMC, is that the Fed did not realize that inflation would rise so much in 2021 and, if they had, they would have raised rates in fall 2021 instead of spring 2022. The “they should have known” explanation, advanced most prominently by Larry Summers, is that the Fed should have known that inflation would rise and raised rates sooner.


Much of the discussion of the Fed being behind the curve depends on subjective analysis of when liftoff from the ELB should have occurred. In a new version of a paper that includes the June 2022 Summary of Economic Projections (SEP), “Policy Rules and Forward Guidance Following the Covid-19 Recession,” we use data from the Summary of Economic Projections (SEP) from September 2020 to June 2022 to compare policy rule prescriptions with actual and FOMC projections of the FFR. This provides a precise definition of “behind the curve” as the difference between the FFR prescribed by the policy rule and the actual FFR.


The FOMC adopted a far-reaching Revised Statement on Longer-Run Goals and Monetary Policy Strategy in August 2020. The framework contains two major changes from the original 2012 statement. First, policy decisions will attempt to mitigate shortfalls, rather than deviations, of employment from its maximum level. Second, the FOMC will implement Flexible Average Inflation Targeting where, “following periods when inflation has been running persistently below 2 percent, appropriate monetary policy will likely aim to achieve inflation moderately above 2 percent for some time.”


At its September 2020 meeting, the Committee approved outcome-based forward guidance, saying that it expected to maintain the target range of the FFR at the ELB “until labor market conditions have reached levels consistent with the Committee’s assessment of maximum employment and inflation has risen to 2 percent and is on track to moderately exceed 2 percent for some time.”


If the Fed had followed a policy rule using inflation and unemployment data from the FOMC’s quarterly SEP’s instead of the FOMC’s forward guidance,  they could have avoided the pattern of falling behind the curve, pivot, and getting back on track that characterized Fed policy during 2021 and 2022. The rules prescribe liftoff from the ELB in 2021:Q2 or 2021:Q3 and a much smoother path of rate increases through the end of 2022 than that adopted/projected by the FOMC. Since the rules use data from the SEP rather than inflation and unemployment expectations, it makes the “we didn’t know” explanation irrelevant and the “they should have known” explanation unnecessary.


We consider six policy rules. The Taylor (1993) rule prescribes that the FFR equal the inflation rate plus 0.5 times the inflation gap, the difference between the inflation rate and the 2 percent inflation target, plus 1.0 times the unemployment gap, the difference between the rate of unemployment in the longer run and the realized unemployment rate, plus the neutral real interest rate. The balanced approach rule in Yellen (2012) raises the coefficient on the unemployment gap to 2.0 while maintaining the coefficient of 0.5 on the inflation gap. The Taylor and balanced approach (shortfalls) rules are identical to the original rules except that they do not prescribe a rise in the FFR when unemployment falls below longer-run unemployment.


Neither the original nor the shortfalls rules are consistent with the revised statement. We introduce two new rules in accord with the revised statement that we call the Taylor and balanced approach (consistent) rules. First, we replace the rate of unemployment in the longer run with the unemployment rate consistent with maximum employment and base FFR prescriptions on shortfalls instead of deviations. Second, if inflation rises above 2 percent, the rule is amended to allow it to equal the inflation rate “moderately” above 2 percent that the FOMC is willing to tolerate “for some time” before raising rates in order to bring inflation down to the 2 percent target.


Starting with the original Taylor rule, normative policy rule prescriptions are typically “non-inertial” as the prescribed FFR depends on the realized values of the right-hand-side variables. Following Clarida, Gali, and Gertler (1999), estimated Taylor-type rules are typically “inertial” to incorporate slow adjustment of the actual FFR to changes in the prescribed FFR. Policy rule forward guidance, however, involves normative policy rule prescriptions that need to be inertial when inflation rises quickly in order to be in accord with the FOMC’s desire to smooth out large rate increases over time. We follow Bernanke, Kiley, and Roberts (2019) and specify inertial rules with a coefficient of 0.85 on the lagged FFR and 0.15 on the target level of the FFR specified by the corresponding non-inertial rule.


The figure depicts the actual FFR for September 2020 to June 2022 and the projected FFR for September 2022 to December 2024 from the June 2022 SEP. Panels A and B illustrate prescriptions from the non-inertial rules. Five of the six rules prescribe liftoff from the ELB in 2021:Q2, three quarters earlier than the actual liftoff. All of the non-inertial rules prescribe unrealistic jumps in the FFR. For the Taylor rules, there are prescribed jumps of at least 200 basis points in 2021:Q2 and 2021:Q4 and, for the balanced approach rules, there is a 275 basis point jump in 2021:Q4.  The prescribed rate increases peak in 2022 and are mostly 50 basis points below the FOMC projections at the end of 2024.

Panels C and D show prescriptions from the inertial rules. The prescribed liftoff from the ELB is slightly later than with the non-inertial rules, 2021:Q2 for the Taylor rules and 2021:Q3 for the balanced approach rules. The inertial rules prescribe much more realistic paths for the FFR than the non-inertial rules. Most of the prescribed rate increases are 25 basis points and there are no increases greater than 50 basis points. The prescribed FFR’s with the inertial rules continue to increase but much more slowly than those with the non-inertial rules. They peak in 2023 and are mostly 25 basis points above the FOMC projections at the end of 2024.


We focus on the balanced approach (consistent) rule through March 2022 because it is in accord with the Fed’s preference for balanced approach rules and the revised statement. In March 2022, the FFR was 1.5 percent below the policy rule prescriptions. By June 2022, high inflation had become the Fed’s priority. It had met its employment goals, clearly exceeded its inflation goals, and was not going to raise interest rates if unemployment rose from 3.6 percent to its longer-run value of 4.0 percent. We therefore shift focus to the balanced approach (shortfalls) rule. By June 2022, the gap fell to 1.25 percent and, by December 2022, it is projected to further narrow to 0.5 percent. The FOMC could eliminate the gap by the end of 2022 by implementing 50, rather than 25, basis point rate increases in November and December 2022.


From the policy rule perspective, the FOMC fell behind the curve by following its forward guidance and delaying rate increases for too long. If the FOMC had followed policy rule forward guidance with an inertial rule, it would not have fallen behind the curve in 2021, placing it in a much better position to respond when inflation rose and avoiding the series of large rate increases in 2022. To get back on track by the end of 2022, the FOMC would need one 25, four 50, and two 75 basis point rate increases. By following the policy rules, it would still need four 50 basis point rate increases but would not need any 75 basis point increases.


This post written by David Papell and Ruxandra Prodan.