Assessing central bank policy in the post-pandemic economy

Following two of the largest economic shocks of recent history, global central banks are approaching a critical juncture.

Stagnant global growth amid a structural economic shift demands a policy response by central banks still attempting to restore price stability.

This makes decisions on when to pivot toward less restrictive policy rates to support growth and employment all the more important.

The International Monetary Fund forecasts inflation in the advanced G7 countries (the United States, Japan, Germany, France, Italy, the United Kingdom and Canada) dropping to 2.6% this year and reaching the 2% rate targeted by their central banks next year. This should allow the central banks to lower their policy rates, which will help increase demand and bolster the need for labor.

Identifying optimal policy rates in a wide variety of economies is next to impossible, even in stable conditions.

Doing so under current economic conditions, with the reshoring of supply chains and geopolitical conflict, is perilous at best.

But that is exactly what global central banks need to do this year to support what has become, in most economies, a tepid economic recovery.

In the sections that follow, we apply our version of the Taylor Rule to see just what central bankers are thinking.

Using the Taylor Rule

The economist John Taylor devised a method to rationalize the behavior of central bankers. Taylor found that central bankers responded to rising prices by raising interest rates and responded to slow growth by lowering them.

Over time, his rule of thumb has been modified to use the unemployment rate to measure the output gap. The basics of the Taylor Rule are as follows:

In the United States, this equation fits in with the Federal Reserve’s dual mandate to minimize inflation while maintaining full employment. A simplified equation for the dual mandate looks like this:

Policy rate = (real interest rate + inflation rate) + (excess inflation) – (excess unemployment)

The first term, (real interest rate + inflation rate), forms the base value of the policy rate.

The traditional value of r-star, the unobservable real interest rate when an economy is at full strength and inflation is stable, is 2%. That rate represents the underlying level of a return required by an investor in the absence of inflation.

Because of the normal presence of inflation, investors will require the real rate plus the inflation rate to protect the value of their investment.

We note that r-star is thought to vary along with changes in the economy’s potential rate of growth. In today’s economy, we think r-star in the United States is closer to 1% than 2%. But because of the positive impact of fiscal initiatives and increased productivity, we think r-star is increasing once more as the economy’s potential increases.

The federal funds rate, set by the Federal Reserve, is the overnight foundational rate for all other interest rates. It embodies the natural rate of interest plus additional compensation for inflation, onto which investors will attach additional compensation for event risk and credit risk.

In normal circumstances, if inflation is on target at 2% and there is full employment, then the Fed would set its funds rate to 4%, which is the sum of the assumed 2% real interest rate plus the inflation rate of 2%.

But there is almost always some element of excess inflation or excess unemployment that needs to be addressed.

We determine excess inflation as equal to the actual inflation rate minus the target rate, with most central banks setting the target at 2%.

For example, with inflation hovering at 2.7% in April, still above the Fed’s 2% target, there is a 0.7 percentage point of excess inflation.

We determine excess unemployment as the actual unemployment rate minus the unemployment target. The unemployment target is referred to as NAIRU, the natural rate of employment that does not cause inflation to accelerate.

In simple terms, if unemployment is too low, that implies a scarcity of workers, who can demand higher wages that in turn push up prices. Conversely, if unemployment is too high, that implies a scarcity of jobs and lower income, creating a drag on the economy and the need to lower the cost of investment and credit.

In another example, the unemployment rate has hovered around 3.7% for the past 12 months, which is below the 4% estimated value of NAIRU. That implies a hot labor market and an additional 0.3 percentage point that will be factored into determining the Fed’s policy rate.

Under normal circumstances, excess inflation and excess unemployment are given equal weight in the equation by setting alpha and beta equal to 0.5. Observers have suggested that central bankers will assign more weight to excess inflation or excess unemployment at various stages of the business cycle.

Taylor’s original intent was to mimic the behavior of central bankers rather than develop a single rule that would dictate policy. In any case, Taylor’s equation provides policymakers with a simple rule of thumb in the search for the optimal policy rate to support price stability, full employment and economic growth.

In the sections that follow, we have altered the value of the real rate to capture the impact of diminished growth on expectations for return on investment within economies performing below their potential. And we have substituted the average unemployment rate for traditional values of NAIRU to better capture changes in the labor market preferences brought about by the pandemic and by increased business investment in technology and productivity.

United States

For the past two years, the Fed has been operating under the assumption that a natural real rate of 2% was appropriate for an economy with 4% unemployment and low inflation. Applying the standard Taylor Rule to these parameters suggests that holding the federal funds rate at 5.5% for the past 11 months has been only somewhat restrictive, with an appropriate setting of 5.1% as of April.

An alternative scenario that we think better captures the current condition of the U.S. economy is an equilibrium unemployment rate of 3.6%, a neutral real rate of 1.1% and the personal consumption expenditures index—a gauge of inflation closely watched by the Fed—as the policy variable, which elicits an optimal policy rate of 3.85%.

While both scenarios suggest that the Federal Reserve has room to cut rates if inflation decelerates, the central bank will likely engage in only two 25-basis-point cuts, with the option of more. 

Canada

The Bank of Canada’s tight monetary policy is working. This is evidenced by considerable weakness in business investment and economic activity in the second half of last year and the drop in the inflation rate to 2.8%, within the Bank of Canada’s target range of 1% to 3%.

A traditional Taylor Rule model indicates that a rate cut from 5% to 4.5% would be appropriate, given the unemployment rate creeping back above 6% in March. But the prospect of only moderate growth and the need to absorb recent immigrants into the labor market suggest additional cuts.

Based on a decrease in potential growth of gross domestic product that implies a drop in the real rate of interest from 2% to 1%, and with the realignment of the labor market, the equilibrium unemployment rate has fallen to 5.4%. Our modified Taylor Rule suggests that a policy rate of less than 4% would be appropriate until the economy is back on its feet. 

United Kingdom

Our Taylor Rule assessment of the Bank of England’s monetary policy suggests that if the UK inflation rate were to continue its rapid descent, the Bank of England’s 5.25% policy rate would be at risk of becoming overly restrictive.

The inflation rate of 2.3% as of April is only fractionally above the central bank’s 2% target.

At the same time, the labor market has become less of a concern. The unemployment rate is once more centered on 4%, and the bank is pointing to moderation of nominal wage growth and some loosening in what has otherwise been a relatively tight labor market. We are assuming a neutral rate of unemployment of 4% in our Taylor Rule calculations.

The sluggish growth is another matter. We are assuming that the real rate of interest, which most likely fell to 1% during the era of near-zero interest rates and austerity, remains suitable during this period of sluggish economic growth.

Our Taylor Rule model therefore suggests that a policy rate of 4.5.% is appropriate within the resolution of policy objectives.

Euro area

The European Central Bank had all but stated its intention to lower its policy rate two months before the June meeting, noting that most measures of underlying inflation were easing, wage growth was moderating and firms were absorbing the rise in labor costs.

With the inflation rate dropping to 2.4% in March, the unemployment rate settled into its 6.5% average of the post-pandemic era, and our Taylor Rule analysis suggested that rate cuts to roughly 3.7% would have already been appropriate.

Our Taylor Rule calculation assumes a natural rate of interest of 1% for the euro area, based on the decline in economic activity. Whether the economic stagnation is a result of the conflict in Ukraine or competition from China or the tightness in monetary policy seems immaterial at this point. The time seems right for easing monetary policy.

Once the inflation rate drops to the central bank’s 2% target, which we expect next year, and given the current state of economic growth, a policy rate on the order of 3% would then be appropriate.

Australia

Australia’s monthly inflation rate dropped to 3.6% in the first quarter, but it is still well above the Reserve Bank of Australia’s target of 2% to 3%.

The unemployment rate has crept back up to 4.1% in recent months, above its 3.8% average since January 2022, even as real gross domestic product growth has declined to 1.5%, roughly half of Australia’s growth rate in the pre-pandemic era.

The most reasonable argument, then, is that rates can stay higher for longer to  quash inflation.

Our Taylor Rule model assumes a real rate of 1%, in recognition of competition from Asia on Australia’s expected return on investment. And while the central bank notes that NAIRU is somewhere around 4.5%, we have nudged those estimates down to 4%, based on the performance of the post-pandemic labor market.

Plugging those parameters into our equation suggests a policy rate closer to 5%, well above the cash rate’s peak of 4.35% that has been in effect since last November. That implies monetary policy will continue to be insufficiently restrictive, but perhaps suitable with regard to other policy motives.