Oregon Office of Economic Analysis

The combination of the QE tapering talk by the Federal Reserve a few months back and now the turmoil in Washington D.C. over the budget and debt ceiling have raised interest rates across the board recently. Over the past 4-5 months interest rates have increased by about 1 full percentage point. Market expectations shifted as the Federal Reserve talked of drawing down QE in late 2013 and possible rate hikes in 2014 and now the probability of the U.S. government defaulting on their debt is increasing. (Data from FRED)

While the will they or won’t they pass a budget and raise the debt ceiling is touch and go by the hour these days, the real question is when should the Federal Reserve raise interest rates? Should they wait for the fundamental economic growth to be strong enough, try to stem off potential financial bubbles as early as possible, etc? Where are we today in this process and are rate hikes just around the corner? Below is an updated on our office’s standard interest rate graph (seen previously as well).

According to the Mankiw Rule, a Taylor Rule type calculation by Harvard Professor Greg Mankiw, rates should already be a bit above zero, while using the Fed’s own forecasts, a rate hike in 2014 is likely, while IHS Global Insight is holding out for the first rate hike in mid-2015. So which is the likely path of policy? Well, I certainly don’t know exactly, but we do know that most of the rise in the Mankiw Rule calculation is due to an “improving” unemployment rate. However we also know that the unemployment rate is improving, at least a good portion of it, for bad reasons, not good reasons. This makes it a deceiving variable to use and overstates the improvement in the economy. I would argue that renders the Mankiw Rule estimates of the fed funds rate inappropriate today.

In turn, I reestimated a Taylor Rule type calculation using the output gap as the measure for economic performance. This yields results similar to the estimates using the Fed’s own forecasts and methodology. These Taylor Rule type calculations imply an interest rate hike in the second half of 2014.

But again, IHS Global Insight still believes the rate hikes won’t begin until 2015 at the earliest, what gives? This likely comes down to the fact that the Federal Reserve is trying to say they will continue to hold down interest rates even in the face of these standard, Taylor Rule type calculations. They will not raise rates immediately, at the first sign of an improved recovery or a short-term pickup in inflation. As Paul Krugman likes to say, going back to his Japanese liquidity trap paper, the strategy is for the central bank to credibly promise to be irresponsible. It is a tough sell after decades of building up credibility and with all the talk of the Fed tapering QE in previous months, it is something markets likely aren’t buying all the way either.

With all this being said, the likelihood of a near-term rate hike is low given the lackluster economic recovery and low levels of inflation. The most recent Washington D.C. turmoil, if anything, has further delayed any tightening in terms of Fed policy. The economic fundamentals and forecasts tend to say a year from now the Fed may raise rates, however this is conditional on actual economic growth in the coming year. Reasons for diverging from this type of outlook would be to raise rates sooner should an asset bubble arise and the Fed wishes to try and deflate it or to delay raising rates even longer until after economic conditions warrant a rise, in order to ensure the strength of the recovery and not tighten too soon. Of course this is all conditional on the U.S. not hitting the debt ceiling and the economy falling back into recession. Should that occur, it will be considerably longer before we leave the zero lower bound.