Inflation has risen sharply in recent months. In November, HICP inflation in the eurozone reached 4.9% (according to Eurostat's flash estimate). PCE inflation in the US reached 5.0% year-over-year in October, while UK CPI inflation was 4.2%, Nevertheless, the Federal Reserve (Fed), the European Central Bank (ECB) and the Bank of England have left interest rates unchanged. Furthermore, the Fed and the ECB signalled that they will not raise interest rates for many more months.
Reaction functions
Looking at central bank ‘reaction functions’ makes it even more difficult to understand why central banks are not raising interest rates. Reaction functions capture the idea that central banks set interest rates in relation to a few observed variables, in a numerically stable way. For instance, the celebrated ‘Taylor rule’ holds that the Fed’s setting of the Federal funds rate between 1987-1993 could be seen as determined by a simple equation or ‘rule’.
According to the rule, the Federal funds rate is well captured by the neutral real interest rate plus the rate of inflation, plus ½ times the deviation of inflation from 2%, plus ½ times the size of the output gap. Using data from FRED, the Fed’s public data base,2 the Taylor rule suggests that the Federal funds rate should now be 8.55%. Plainly, if the Fed were to set interest rates at this level, the US economy would collapse. A more relevant implication of the Taylor rule is that the Federal funds rate should rise by 150 basis points in response to a one percentage point increase in inflation.
But no central bank sets interest rates according to a fixed rule with the help of a pocket calculator. There are four main reasons for that. In declining order of importance for explaining why central banks do not raise interest rates now, they are:
- Central banks do not react to inflation and economic activity but to the underlying disturbances that cause economic fluctuations
- The expected persistence of economic shocks matters. Since monetary policy impacts inflation with lags of between 6 and 12 quarters, it makes little sense to respond to a surge in inflation if the rise is likely to be temporary.
- Reaction functions disregard many other factors that are important when setting interest rates. These include the state of the financial system, which determines how effective monetary policy is, and inflation expectations that may move very little in response to movements in observed inflation.
- The neutral real interest rate (r*) is not constant, but appears to have fallen to close to, or even just below, zero. As r* declines, a central bank must reduce the interest rate it sets.
Overall, reaction functions are too simple to be used to set monetary policy in practice.