Thursday, July 01, 2004

Somebody check my math 

I am teaching money and banking this term, and as you would guess we've been keenly tuned to the happenings at the Federal Reserve this week. Jeffrey Tucker at Mises blog points to this morning's New York Times article that suggests the Fed has been (again) too slow to respond to market conditions, this time allowing inflation to get ahead of it. came as a surprise to some economists and portfolio managers that Fed policy makers thumbed their nose at inflation worries in the statement accompanying the rate increase. "Although incoming inflation data are somewhat elevated, a portion of the increase in recent months appears to have been due to transitory factors," the policy makers said.

That is not the opinion of Alan W. Kral, portfolio manager at Trevor Stewart Burton & Jacobsen in New York. "We believe that inflation has returned," Mr. Kral said. "And the cause of it has been an overexpansive monetary policy for almost 10 years."

..."I believe the Fed is behind the curve because the economy continues to be strong and the inflation rate is creeping up and will continue to creep up," said Henry Kaufman, an economist in New York. Its plan to raise interest rates gradually may be good for the economy, he said, "but is not designed to put the system back into balance in terms of constraining inflation itself."

The Mises Institute people recently put up this article by Frank Shostak discussing the troubles of the Taylor Rule, which is used as a forecasting tool for what Federal Reserve policy regarding the federal funds rate target will be. That's important to emphasize: Nobody should believe that the Fed is actually using this formula, only that the formula seems to mimic what rates they tend to set. I have created macro models for some ministries of finance in developing countries, and we sometimes have used a Taylor-esque rule in the model simply so the ministry can guess at what the central bank will do. The central bankers would tell us they don't use the Taylor rule. We would reply that it didn't matter what they used, the equation was a fair approximation of whatever the heck it was they were doing.

The formula for the rule is

target FF rate = 2% + current inflation + 1/2*(deviation of inflation from 2%) + 1/2*(percentage gap of GDP from its potential level)
So let's check the current 1.25% target set by the Fed. Now one can argue that raising the Fed Funds rate that fast is going to be too disruptive and a more gradual approach is needed. Fine. But that does not obviate the fact that you would have arrived at something around 2% last winter (see the chart in Shostak's article FMI.) The FOMC meets every five weeks. The question of why they waited until now, and why they are being so gradualist, is a very good question.