The Federal Open Market Committee is widely expected to leave its policy rate unchanged at this week’s meeting. The CME Group puts the odds that the FOMC will continue to target the federal funds rate within the 3.5 to 3.75 percent range at 99.5 percent. But the near certainty regarding this week’s decisions masks the growing problem Fed officials face.
The rise in energy prices tied to the conflict with Iran is the sort of negative supply shock that makes monetary policy especially difficult. It puts upward pressure on inflation even as it threatens to slow growth and weaken employment.
That puts the Federal Reserve in an awkward position. Under its dual mandate, the Fed is supposed to promote both price stability and maximum employment. Ordinarily, Fed officials have the luxury of focusing on one of those objectives at a time. When inflation is increasing, the Fed can raise rates to cool demand. When growth slows and unemployment rises, it can cut rates to support spending and hiring. An adverse supply shock is different because it simultaneously threatens both goals.
What the Rules Say
The difficulty posed by adverse supply shocks makes it all the more important to seek guidance from monetary rules. The latest Monetary Rules Report from AIER’s Sound Money Project shows that the Fed’s current policy rate already sits near the lower end of the recommended range.
The Taylor Rule remains the most familiar place to start. It says that the Fed should set interest rates higher when inflation runs above target and lower when economic activity or employment fall below sustainable levels. Using the most recent data available, the original version of the rule points to a federal funds rate of 4.66 percent. A modified version that minimizes interest rate volatility and accounts for forecasts of future inflation implies a policy rate of 3.99 percent. If anything, the Taylor Rule suggests Fed officials ought to consider an increase in the federal funds rate target.
Rules based on nominal gross domestic product, or NGDP, suggest somewhat lower rates, with an NGDP level rule at 3.93 percent and an NGDP growth rule at 3.53 percent. These estimates are in line with the current stance of policy and support the expected decision to hold steady at 3.5–3.75 percent.
How Rules Account for Supply Shocks
In normal circumstances, both types of rules provide a useful way to translate incoming data into a policy rate prescription. But supply shocks make the Taylor Rule harder to interpret, because they create conflicting signals. Higher energy prices put upward pressure on inflation, which points toward tighter policy. At the same time, they raise production costs and squeeze household budgets, which can weaken output and employment, pointing toward easier policy. As a result, the Taylor Rule gets pulled in opposite directions.
That tension has also shown up in recent commentary from policymakers. Some of the more dovish voices inside the Fed and around the administration — who have been quite eager to lower rates — have admitted that any cuts are more likely to come later in the year, after the current Middle East conflict subsides. That shift reflects how difficult it is to formulate policy when a negative supply shock strains both sides of the Fed’s mandate at once.
A Better Guide During Supply Shocks
This is where rules based on nominal spending become especially useful. NGDP is simply the total dollar value of spending in the economy. Its growth rate combines inflation and real output growth into a single measure. That makes it an especially useful guide when supply shocks hit. Instead of forcing policymakers to weigh inflation and growth separately, NGDP rules ask a broader question: what is happening to total spending?
The NGDP growth rule, for instance, suggests that monetary policymakers aim for annual 4 percent growth in nominal spending. The 4 percent benchmark reflects the fact that the Fed targets a 2 percent inflation rate and annual output growth tends to average 2 percent. It effectively wraps both sides of the Fed’s dual mandate into a single statistic. Importantly, in the context of a negative supply shock, it also accommodates offsetting movements in those two objectves. For instance, if spiking energy prices push inflation to 3 percent and pull real growth down to 1 percent, overall NGDP growth would remain at 4 percent and the Fed would be justified in keeping rates steady — despite inflation moving temporarily above target.
In other words, if oil prices rise because of geopolitical conflict, inflation may move higher even though overall spending is not accelerating in a way that calls for tighter monetary policy. At the same time, weaker real growth alone does not necessarily mean the Fed should cut, so long as nominal spending remains reasonably stable. Looking at NGDP helps policymakers avoid overreacting to only one dimension of the shock.
In the April report, the NGDP rules are broadly consistent with leaving policy unchanged. The NGDP growth rule, in particular, suggests that current policy is roughly on target, with the most recent data showing NGDP growth of 4.2 percent — very close to the rule’s 4 percent benchmark. That figure is backward-looking, so it is reasonable to worry that it may not fully capture recent developments tied to the conflict in the Middle East. Even so, more recent inflation data and forecasts of real output growth still point to nominal spending growth of around 4 percent. That reinforces the case for keeping policy where it is.
What This Means for the Fed
Supply shocks create some of the most challenging problems for monetary policymakers because they blur the line between inflation risk and economic weakness. That is what makes the current moment so uncomfortable for Fed officials. But discomfort need not mean confusion. The leading rules still offer a useful signal: when overall nominal spending remains close to trend, policymakers should be careful not to overreact to either dimension of a supply disturbance. Fed officials can remain confident by keeping policy within the range offered by the leading monetary policy rules.
The Federal Open Market Committee is widely expected to leave its policy rate unchanged at this week’s meeting. The CME Group puts the odds that the FOMC will continue to target the federal funds rate within the 3.5 to 3.75 percent range at 99.5 percent. But the near certainty regarding this week’s decisions masks the growing problem Fed officials face.
The rise in energy prices tied to the conflict with Iran is the sort of negative supply shock that makes monetary policy especially difficult. It puts upward pressure on inflation even as it threatens to slow growth and weaken employment.
That puts the Federal Reserve in an awkward position. Under its dual mandate, the Fed is supposed to promote both price stability and maximum employment. Ordinarily, Fed officials have the luxury of focusing on one of those objectives at a time. When inflation is increasing, the Fed can raise rates to cool demand. When growth slows and unemployment rises, it can cut rates to support spending and hiring. An adverse supply shock is different because it simultaneously threatens both goals.
What the Rules Say
The difficulty posed by adverse supply shocks makes it all the more important to seek guidance from monetary rules. The latest Monetary Rules Report from AIER’s Sound Money Project shows that the Fed’s current policy rate already sits near the lower end of the recommended range.
The Taylor Rule remains the most familiar place to start. It says that the Fed should set interest rates higher when inflation runs above target and lower when economic activity or employment fall below sustainable levels. Using the most recent data available, the original version of the rule points to a federal funds rate of 4.66 percent. A modified version that minimizes interest rate volatility and accounts for forecasts of future inflation implies a policy rate of 3.99 percent. If anything, the Taylor Rule suggests Fed officials ought to consider an increase in the federal funds rate target.
Rules based on nominal gross domestic product, or NGDP, suggest somewhat lower rates, with an NGDP level rule at 3.93 percent and an NGDP growth rule at 3.53 percent. These estimates are in line with the current stance of policy and support the expected decision to hold steady at 3.5–3.75 percent.
How Rules Account for Supply Shocks
In normal circumstances, both types of rules provide a useful way to translate incoming data into a policy rate prescription. But supply shocks make the Taylor Rule harder to interpret, because they create conflicting signals. Higher energy prices put upward pressure on inflation, which points toward tighter policy. At the same time, they raise production costs and squeeze household budgets, which can weaken output and employment, pointing toward easier policy. As a result, the Taylor Rule gets pulled in opposite directions.
That tension has also shown up in recent commentary from policymakers. Some of the more dovish voices inside the Fed and around the administration — who have been quite eager to lower rates — have admitted that any cuts are more likely to come later in the year, after the current Middle East conflict subsides. That shift reflects how difficult it is to formulate policy when a negative supply shock strains both sides of the Fed’s mandate at once.
A Better Guide During Supply Shocks
This is where rules based on nominal spending become especially useful. NGDP is simply the total dollar value of spending in the economy. Its growth rate combines inflation and real output growth into a single measure. That makes it an especially useful guide when supply shocks hit. Instead of forcing policymakers to weigh inflation and growth separately, NGDP rules ask a broader question: what is happening to total spending?
The NGDP growth rule, for instance, suggests that monetary policymakers aim for annual 4 percent growth in nominal spending. The 4 percent benchmark reflects the fact that the Fed targets a 2 percent inflation rate and annual output growth tends to average 2 percent. It effectively wraps both sides of the Fed’s dual mandate into a single statistic. Importantly, in the context of a negative supply shock, it also accommodates offsetting movements in those two objectves. For instance, if spiking energy prices push inflation to 3 percent and pull real growth down to 1 percent, overall NGDP growth would remain at 4 percent and the Fed would be justified in keeping rates steady — despite inflation moving temporarily above target.
In other words, if oil prices rise because of geopolitical conflict, inflation may move higher even though overall spending is not accelerating in a way that calls for tighter monetary policy. At the same time, weaker real growth alone does not necessarily mean the Fed should cut, so long as nominal spending remains reasonably stable. Looking at NGDP helps policymakers avoid overreacting to only one dimension of the shock.
In the April report, the NGDP rules are broadly consistent with leaving policy unchanged. The NGDP growth rule, in particular, suggests that current policy is roughly on target, with the most recent data showing NGDP growth of 4.2 percent — very close to the rule’s 4 percent benchmark. That figure is backward-looking, so it is reasonable to worry that it may not fully capture recent developments tied to the conflict in the Middle East. Even so, more recent inflation data and forecasts of real output growth still point to nominal spending growth of around 4 percent. That reinforces the case for keeping policy where it is.
What This Means for the Fed
Supply shocks create some of the most challenging problems for monetary policymakers because they blur the line between inflation risk and economic weakness. That is what makes the current moment so uncomfortable for Fed officials. But discomfort need not mean confusion. The leading rules still offer a useful signal: when overall nominal spending remains close to trend, policymakers should be careful not to overreact to either dimension of a supply disturbance. Fed officials can remain confident by keeping policy within the range offered by the leading monetary policy rules.
