Is the Fed behind the curve?

I have addressed many of the issues concerning the question of whether or not the Fed is behind the curve in two recent commentaries1. There are two dimensions to being 'ahead' or 'behind' the curve. The first dimension is the traditional perspective on the federal funds rate. The second is the bloated state of the Fed’s balance sheet that imparts monetary stimulus via its effect on long term interest rates.

Many observers are focused on the real Fed funds rate and conclude that the Fed is behind the curve because a central bank supposedly should not persist with a negative real policy rate at full employment. That is correct, but the question remains as to 'how much?" The answer to that question depends critically on what the neutral policy rate is and the prospective risks to financial stability. My fed funds model, which includes a proxy for systemic risk to address the Fed's foremost priority of safety and soundness of the financial system as well as measures of the Fed’s other two objectives of price stability and full employment, gives a new perspective on how much the Fed might be behind the curve. Figure 3 from my paper entitled "Policy Rules Versus Discretion: Lessons from History", is reproduced below. Over the past year, the Fed has closed the gap behind the funds rate and its estimated value in this model to about 35 basis points. Granted, the model expects the funds rate to rise further now that the economy is at full employment and inflation is inching up to its target of 2%. But the ultimate nominal neutral rate in this model is 2% to 2-1/2% - far lower than most observers perceive it to be yet a target consistent with staff and IMF studies on the new neutral rate. In this context, the Fed would be judged to be a little behind the curve, albeit not as much as they often are at full employment.

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