The Basis of the Rate Increases
The Taylor rule is a policy tool used in monetary policy. It consists of three different components to help guide interest rate decisions in the economy. The first expression represents the natural rate of interest that should exist in harmonious equilibrium. The last two expressions adjust the ideal interest rate based on the current status of employment and inflation.
The Federal Reserve is known to use the Taylor rule frequently. For instance, before the Great Recession of 2008, the fed funds rate, an interest rate target governed by monetary policy, closely followed the predicted interest rate given by the Taylor rule. However, since the Great Recession, the Taylor rule has been less reflective of actual interest rates. Purposefully, the fed funds rate policy has remained far below the interest rate indicated by the Taylor rule.
Since the beginning of the year, interest rates and the Federal Reserve have come into the headlines. Fed governors that speak publicly have come across as sounding more hawkish, meaning that the Fed will be more aggressive about raising interest rates. The Federal Reserve's dot plot, a projection of future interest rates, shows that all twelve governors expect the fed funds rate to exceed two percent by the end of 2023. Present rhetoric offered by public officials appears reminiscent of when the Taylor rule was the primary objective tool.
The fed funds rate, the rate banks charge on financial reserves, resides between a quarter and a half of one percentage point today. The two economic mandates regulated by the Federal Reserve, employment and inflation, would likely warrant higher short-term interest rates based on the Taylor Rule, specifically based on the employment and inflation components. Today's employment situation shows record low levels of unemployment. Moreover, there certainly isn't enough participation in labor markets, as the economy could absorb eleven million more workers. On the other hand, the inflation genie is out of the bottle and the Federal Reserve is clearly focused in on managing this force. In regular times, both variables would call for interest rate increases.
The hope is that the economy will steer in the right direction now that the time has come to raise the cost of interest due to inflation. There are fewer disincentives to hold large quantities money when inflation and interest rates run low. As a result, stockpiles of financial wealth accumulate in bank sectors and eventually cause inflation once the money gets unleashed in the economy and chases a finite number of goods and services. As the bank cycle progresses, underinvestment in productive physical assets happens until the point at which inflation eliminates the incentive to hold value in a currency.
Today's warranted shift in resource allocations can do good things for the economy. Instead of wealth creation through money acquisition, the economy should start to refocus attention on how to use physical resources more efficiently with new investments in physical assets. The result should begin to increase productivity through better utilization of resources and, in effect, drive down the rate of excessive inflation. So far, interest rate governors appear successful at moving the pace of change. Specifically, productive areas of the economy such as manufacturing and services remain in expansion, while the growth of financial wealth, which can contribute to inflation, has stalled.
Financial investments have generally fallen in value this year primarily due to the Federal Reserve activity and communication. As a result, financial ownership in stocks, bonds, and cash has declined in value, while physical ownership, such as land and natural resources, has appreciated. However, the financial markets over the recent past clearly evidence investors’ willingness to accept financial risk to pursue business profits. Moreover, a look back at the past three years shows incredible advantages to business equity ownership over the returns generated by bonds. This seems to be an encouraging sign of economic progress, and the heightened focus on improving economic productivity should hopefully support continued economic and business growth.
