Is the Fed Behind the Curve?

On Wednesday the Federal Reserve is set to raise the fed funds rate by 25 basis points. In its December 2016 statement, in which the board raised rates for the second time in 10 years, the FOMC​ said they see three hikes in 2017. However, key indicators suggest the Fed needs to begin tightening at a faster pace than stated or it risks falling behind the curve, if it hasn't already. 

A central bank gets behind the curve when it is not raising interest rates at a pace fast enough to keep up with inflation. Conversely, the Federal Reserve can get ahead of the curve by increasing interest rates at a pace faster than inflation suggests it should be. 

Falling Real Rates

Since December 2015, when the Fed first lifted rates from zero, real interest rates have fallen. According to Bloomberg, adjusted for PCE inflation — the Fed's preferred measure of inflation — real interest rates have fallen by 100 basis points to minus 1.2 percent, a level not indicative of an economy that is closing in on achieving its dual mandate of maximum employment and 2 percent inflation. (See also: Breaking Down the Federal Reserve's Dual Mandate)

Source: Bloomberg

Suppressed interest rates in the U.S. have made other asset classes, most notably equities and housing, more attractive. Since the December 2015 hike, U.S. equity markets have risen in excess of 15 percent, reaching all-time highs. With borrowing at record low levels, the housing market has recovered from the financial crisis with prices nearing pre-recession levels. If the Fed is indeed behind the curve and is forced to increase the pace of hikes, it could see a sharp reversal in both equities and house prices. (See also: The Fed, Wall Street, Economists love Rate Hikes)

The Taylor Rule

Further evidence that the Fed falling behind the curve can be found by looking at the relationship between current Fed policy and the Taylor Rule. The Taylor Rule, developed by Stanford economist John Taylor, is a mathematical formula that seeks to target the fed funds rate using the current inflation rate and real GDP. The formula uses a base fed funds rate of 2 percent, its historical average. The formula is r = p + .5y + .5(p – 2) + 2 where p is current inflation and y is the deviation of real GDP from a target. 

Using this model, the Fed is up to 300 basis points behind the Taylor Rule target. 

Taylor argued that over accommodative policy between 2003-2005 was a source of the housing bubble. 

The Bottom Line

Since the financial crisis, the U.S. economy has made a steady turnaround, in part due to policy measures undertaken by the Federal Reserve. However, since 2015, when the Fed began to contemplate rate hikes, they have cited many risks for leaving policy rates at record low levels. In 2015, volatility in emerging markets kept the Fed from acting, in the early part of 2016 it was the oil crisis, and the latter half of 2016 the election was the cause for concern. (See also: How Trump Could Quickly Shake Up the Fed)

However, as inflation has picked up and the jobs market remains buoyant, could the real risk for the Fed be not raising rates fast enough?

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