Has the Fed Fallen behind the Curve This Year?

Last December, monetary policy analysts inside and outside the Fed expected several increases in short-term interest
rates this year. Indeed, the median federal funds rate projection in December 2015 by Federal Open Market Committee
(FOMC) participants was consistent with four ¼ percentage point hikes in 2016. So far, none of those increases has
taken place.

Of course, monetary policy decisions are often described as data-dependent, so as economic conditions change, FOMC
projections for the appropriate path of monetary policy adjusts in response. However, as Rudebusch and Williams (2008)
note, changes in forward policy guidance can confound observers and whipsaw investors. In fact, some have complained
that the lower path for the funds rate this year represents an inexplicable deviation from past policy norms. A
reporter described these complaints to Federal Reserve Chair Janet Yellen at the most recent FOMC press conference
(Board of Governors 2016b): “Madam Chair, critics of the Federal Reserve have said that you look for any excuse not to
hike, that the goalpost constantly moves.” Such critics have accused the Fed of reacting to transitory, episodic
factors, such as financial market volatility, in a manner very different from past systematic Fed policy responses to
underlying economic fundamentals.

This Economic Letter examines whether the recent revision to the FOMC’s projection of appropriate monetary
policy in 2016 can be viewed as a reasonable course correction consistent with past FOMC behavior. We first show that
the projected funds rate revision is not large relative to historical forecast errors. Next, we show that a simple
interest rate rule that summarizes past Fed policy can account for this year’s revision to the funds rate projection
based on recent changes to the FOMC’s assessment of economic conditions.

Recent revisions to FOMC economic projections

Four times a year, the FOMC releases a Summary of Economic Projections (SEP), which presents participants’ forecasts
for key economic variables at various horizons. These projections get revised over time as economic conditions evolve.
Table 1 presents the median projections from the December 2015 and September 2016 SEP releases (Board of Governors
2015 and 2016a). The top part of the table reports forecasts for the 2016 values of the federal funds rate, real GDP
growth, the unemployment rate, headline inflation, and core inflation, which excludes energy and food prices. The
bottom part of the table reports the FOMC’s longer-run economic projections, which describe where the economy is
expected to settle after five or so years assuming appropriate monetary policy and the absence of further economic
shocks. Much recent commentary has reassessed and debated the “new normal” for the economy, and these longer-run
projections provide insight into the FOMC participants’ evolving views on this issue (Leduc and Rudebusch 2014).

The first line of Table 1 is the focus of our analysis. The projected funds rate at the end of 2016 was revised down
from 1.4% to 0.6%—a reduction of 0.8 percentage point. This revision in the policy path was accompanied by other
changes in economic conditions. For example, since the end of last year, the median FOMC projection has been revised
to show slower real GDP growth in 2016 and a bit higher unemployment, as the economy slightly underperformed
expectations. At the same time, while core inflation for this year is expected to be a bit higher now than it was last
December, overall price inflation was revised down with lower energy prices.

These economic projections have to be evaluated relative to assessments of the longer-run “normal,” which are also
subject to revision. Of course, the benchmark for inflation hasn’t changed, as the FOMC’s longer-run inflation target
has remained at 2%. But the September 2016 SEP revised the normal or trend growth rate of the economy lower, in part
because of continuing weak productivity (Fernald 2016). Also, the projected normal or natural unemployment rate was
revised down by 0.1 percentage point to 4.8% with news of greater labor force participation. Finally, there is a
notable drop in the longer-run normal funds rate from 3.5% to 2.9%. Since longer-run inflation is fixed at 2%, this
decline translates one-for-one into a lower inflation-adjusted or real normal funds rate. This longer-run neutral or
equilibrium real interest rate—often referred to as r-star—is the risk-free short-term interest rate adjusted for
inflation that would prevail in normal times with full employment. A range of factors appear to have pushed down FOMC
participants’ assessments of the neutral real interest rate including a greater global supply of saving, changing
demographics, and slower trend productivity growth (Williams 2016).

Is the revision to the policy projection unusually large?

In recent years, Fed policymakers have repeatedly indicated that monetary policy is data-dependent, so funds rate
projections will change with new information about the economy. As Fed Chair Yellen (2016) put it, “Of course, our
decisions always depend on the degree to which incoming data continues to confirm the Committee’s outlook. And, as
ever, the economic outlook is uncertain, and so monetary policy is not on a preset course.”

To consider whether the revision to the FOMC’s projected policy path was outsized, Figure 1 provides historical
perspective with a fan chart for the funds rate, a type of graph that many central banks use to communicate policy
uncertainty. The solid black line shows the midpoint of the daily federal funds target range through the December 16,
2015, FOMC meeting, when that range was raised to ¼-½%. The blue dots represent the median projection from that
meeting for end-of-year funds rate levels. For example, in December 2015, the FOMC projected the funds rate would
increase 1 percentage point by the end of 2016 (middle blue dot). In contrast, the median funds rate projection from
the September 2016 FOMC meeting (red dots) shows only a ¼ percentage point hike in the funds rate this year.

One way to gauge whether the revision to this year’s policy path is surprisingly large is to compare it with past
forecast errors. Given the December projection, the shaded fan region in Figure 1 shows an approximate 70% confidence
interval of likely outcomes based on historical forecast accuracy. This range equals the median December 2015
projection plus and minus the average root mean squared prediction error for various horizons subject to a zero lower
bound (Yellen 2016). The September 2016 projection is well inside this confidence interval. That is, the revision in
the projected funds rate this year is not unusual from a historical standpoint. Indeed, given the distribution of past
discrepancies between forecasts and outcomes, the odds were better than even that the funds rate path would be revised
as much as it was in the September projection.

Is the policy revision consistent with past Fed behavior?

Can the moderately sized revision to the policy path since the end of last year be explained by changing economic
circumstances? To answer this, we use a simple interest rate rule of thumb that has been widely employed to describe
past systematic Fed policy reactions (see, for example, Rudebusch 2009, Carvalho and Nechio 2014, and Yellen 2016). In
this policy rule, the funds rate depends on the neutral real interest rate, inflation, and the unemployment gap, which
is measured as the deviation of the unemployment rate from its longer-run normal level. Such rules are often used to
assess whether the level of the funds rate is appropriate. However, important policy concerns that are left
out of the rule can adversely affect the validity of the rule-implied level of the funds rate as a measure of
appropriate policy. Accordingly, we consider a less ambitious question, whether the revision to the 2016
policy path is consistent with the rule. This latter assessment is arguably less affected by factors that are left out
of the rule but are fairly stable over time including, for example, risk management considerations regarding the lower
bound on interest rates or the weak long-term inflation expectations.

Our specific benchmark policy rule recommends lowering the funds rate 1.5 percentage points if core inflation falls 1
percentage point and lowering it 2 percentage points if the unemployment gap rises 1 percentage point. Therefore, the
rule-implied revision to the target funds rate depends on changes in three components:

Funds rate revision = neutral rate revision + (1.5 × inflation revision) – (2 × unemployment gap revision).

This equation can identify potential systematic determinants of a change in the FOMC’s funds rate projection. The
three narrow bars on the right in Figure 2 report the contributions of the three components of the rule-implied funds
rate revision. The projection of a lower longer-run normal funds rate pushes the rule-implied funds rate down by 0.6
percentage point. Thus, a lower new normal for the neutral real rate can account for much of the downward shift in the
appropriate funds rate (Daly, Nechio, and Pyle 2015). A higher unemployment gap—reflecting both a slightly higher
unemployment projection and slightly lower natural rate of unemployment—accounts for another 0.4 percentage point of
the decline in the rule-implied rate. This effect is consistent with Chair Yellen’s message that the economy has “a
little more room to run” (Board of Governors 2016b). Finally, these two factors are partly offset by marginally higher
core inflation, which adds 0.15 percentage point. Similar to other research, we use core inflation in the rule to
avoid overreacting to transitory food and energy price fluctuations. In addition, we use a rule without policy
gradualism following Rudebusch (2006).

Figure 2 compares the total of these three components with the FOMC forecast revision for the 2016 federal funds
rate. The left-hand bar represents the 0.8 percentage point decline in the median FOMC funds rate projection from the
end of last year to September. The second bar from the left reports a total rule-implied funds rate reduction of 0.85
percentage point over that same period. The similar levels of the two wide bars show that the revision in FOMC
participants’ views about appropriate policy in 2016 was consistent with a standard benchmark formulation of how the
Fed reacts to changes in economic circumstances.

Conclusion

The downward shift to the FOMC’s 2016 funds rate projection was not large by historical standards and appears
consistent with past Fed policy behavior in response to evolving economic fundamentals. Therefore, if monetary policy
was correctly calibrated at the end of last year, it likely remains so, and the Fed has not fallen behind the curve
this year.

Fernanda Nechio is a senior
economist in the Economic Research Department of the Federal Reserve Bank of San Francisco.

Glenn D. Rudebusch is director of research and executive vice president in the Economic Research Department of the
Federal Reserve Bank of San Francisco.

References

Board of Governors of the Federal Reserve System. 2015. “Summary of Economic
Projections.” December 16.

Board of Governors of the Federal Reserve System. 2016a. “Summary of Economic
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Board of Governors of the Federal Reserve System. 2016b. “Transcript of Chair Yellen’s Press
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Carvalho, Carlos, and Fernanda Nechio. 2014. “Do People Understand Monetary Policy?” Journal of Monetary
Economics 66, pp. 108–123.

Daly, Mary C., Fernanda Nechio, and Benjamin Pyle. 2015. “Finding
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