It is long standing economic theory that interest rates below a neutral rate are expansionary and contribute to inflation. So what is the “neutral rate”. The Taylor Rule provides an answer. Named after John Taylor who came up with this simple guide for central banks, the formula sets the federal funds rate (the target rate) at the neutral rate plus half the difference between the expected inflation rate and the target inflation rate plus half the difference between the projected GDP growth rate and the target GDP growth rate.
Central bankers applying the Taylor Rule (some do, some don’t, others modify the rule to suit themselves) have degrees of freedom since the formula deals with “expectations” rather than empirical data. But it is nonetheless a useful and widely used guide.
For an extended period the United States Federal Reserve Bank has seen 2% as the “neutral rate” and has set 2% inflation as the target rate. Currently inflation in the United States is 8.5% and in my opinion can be reasonably expected to rise rather than fall. If rising inflation were not expected, the Federal Reserve would not be raising rates to curb inflation.
Projected GDP growth is another matter. Economists differ widely in their forecasts of economic growth. But a modest 3% growth rate is a conservative projection barring recession. Apply these rates and expected rates to the Taylor Formula.
Neutral rate = 2% plus 0.5 x (8.5 -2.0) plus 0.5 x (3.0 - 2.0) = 5.5%. The current Fed Funds rate (as it is commonly labeled) is 0.25 to 0.50%. That is not going to curb inflation and the Fed is gingerly inching the rate up planning a few stepwise increased to end 2022 with a 1.9% Fed Funds rate. That remains both expansionary and inflationary.
What the Federal Reserve Bank is doing is too little and too late.
The situation in Canada is not a dire but still concerning. Canadian inflation was just released at 6.7%, the highest since 1991. Forecast at 3.2% for 2022 and 2.5% for 2023, Canadian GDP growth is already slowing. Using the Taylor formula, Canadian central bank rate should be a more modest 4.8% but Tiff Macklem just set the bank rate at 1%, well behind the curve. Macklem made it clear that higher rates were coming.
You have to ask why American and Canadian central banks are so slow to react, since both current rates are both inflationary and expansionary. When the United States catches cold, Canada typically gets pneumonia so expect the Canadian economic outlook to worsen as inflation rises south of the border and Canada surely follows.
There seems little reason to expect inflation to abate any time soon. The unemployment rate in the United States is reportedly at 3.6% and there are millions of unfilled jobs. Labor has the upper hand in wage negotiation right now and in the face of rising inflation, expect wage growth to accelerate into a traditional wage-price cycle of inflation. Commodity prices are high driven by inane government policies that stifle energy production and constrain the mining industry from anything but a snail’s pace of expansion despite the shift to Electric Vehicles causing surging demand for base metals like nickel and copper. Higher natural gas prices find their way into higher prices for petrochemicals and downstream products like plastics and paint. Higher oil prices drive up transportation costs and prices of agricultural products shipped by truck. Supply disruption from the war in Ukraine is causing corn and grain prices to surge. Higher inflation is built in and unlikely to be restrained by token increases in borrowing costs.
The global energy shortage is an outgrowth of “climate policies” grounded on the pretense that CO2 causes global warming. Meanwhile, the U.S. led sanctions on Russia help fund the Russian invasion of Ukraine - Russia gets about $700 million a day for oil & gas sold to Europe with the artificial price increase more than offsetting reduced shipments. Russia can giggle all the way to the bank. This is Bidenflation, not the Putin price hike.
Tiff Macklem admits inflation is running hotter than forecast.
Higher inflation means higher rates as central banks try to stem the tide. Back to the future? I expect to see a parallel to the late 1970’s and early 1980’s with very high rates and very low economic expansion. Trudeau and Biden are the primary culprits for this dire economic picture but seem oblivious to the damage their policies are doing, doubling down on stupidity in my opinion.