Last week I wrote a blog post in which I updated my outlook for US inflation based on the so-called P-star model.

In that blog post, I argued that my forecast in April 2021 for much higher US inflation essentially had been spot on, but also that inflation now is set to start to inch down relatively fast in the US.

The P-star model basically is a monetarist model that states that inflation is a result of money supply growth being faster than money demand growth.

However, the Federal Reserve normally does not communicate about monetary policy in terms of money supply growth but rather in terms of setting its policy rate.

I am as a (market) monetarist very skeptical about thinking about monetary conditions in terms of interest rates. Instead, I believe that central banks cannot in the longer run control interest rates. Rather, interest rates are determined by structural factors – essentially to clear the market for savings and investment.

What central banks can do is to set a policy rate that is comparable with what the Swedish economist Knut Wicksell called a natural interest rate, R*.

However, to set a policy rate below R* then the central bank will have to increase the amount of money in circulation in the economy. This will, however, cause an acceleration in inflation, which sooner or later will cause the central bank to revise its policy.

When central banks communicate in terms of their policy rate rather than in terms of for example money supply growth (or growth in nominal demand) then it becomes key to understanding the level of R*.

In that sense, we can understand the state of monetary policy by looking at the key policy rate relative to R*.

The problem of course is that we cannot observe R* directly, but we can try to estimate R* from the historical relationship between macroeconomic variables and the policy rate.

Back in February 2021, I presented such a model in a blog post “R* strikes back: The Fed will hike sooner rather than later”.

I have now updated that model and will use the updated model to evaluate US monetary policy over the past two years and to look ahead.

The R* model

This is how I described the variables in my R* model for the US back in February 2021:

“First of all, I look at potential nominal GDP growth (relative to population) growth.

This of course partly reflects the Fed’s inflation target and that we know from the so-called Fisher Equation that high inflation should cause higher nominal interest rates. Furthermore, this also captures the fact that higher productivity growth should be expected to lead to higher interest rates – as we for example recognize it from the so-called Solow growth model.

Second, I use population growth to capture both growth trends as well as for example the impact of changes in savings and risk appetite as a consequence of changes in demographic trends.

Third, even though the Fed’s task is to ensure ‘price stability’ it has not always succeeded in that. The opposite of price stability is price volatility and we, therefore, use a 10-year moving average of yearly changes in inflation to capture the degree of price (in)stability.

Finally, we also want to capture changes in investors’ and consumers’ optimism and pessimism and the general ‘business cycle’, and the general level of economic activity. I could have used unemployment or the output gap, but I also wanted to capture structural-demographic trends so I have used the so-called employment-population ratio as an explanatory variable.”

Furthermore, I took into account in the model that there apparently since 2008 has been a structural shift down in interest rates and yields globally – likely reflecting to a large extent banking regulation.

The graph below shows the effective Fed Funds rate since 1960 and until today and my estimate for R*. The model has been estimated until 2019 so as not to be influenced by lockdowns etc. from 2020.

We see that the model overall fits the development in the Fed funds rate quite well for more than six decades.

Below I will zoom in on the development in the Fed funds rate over the past five years and compare that with R*.

The Fed got it right in 2020, but failed massively in 2021

The US and the global economy and markets were hit by an unprecedented shock in early 2020 when the Covid pandemic spread around the world and governments – also in the US – moved to contain the virus by lockdown the economies and introducing draconian restrictions on civil and economic life.

In the initial phase, the reaction in the financial markets was very close to what we saw in the Autumn of 2008 and all indications were that the US economy would fall into a deep and potentially deflationary recession.

If we look at the model’s prediction of R* then we see that R* dropped sharply in the US in early 2020. In fact, the drop in R* was as sharp and as deep as in 2008 and as in 2008 R* turned negative. In fact R* became even more negative than in 2008.

Contrary to 2008 the Federal Reserve reacted swiftly to the drop in R* and cut the Fed Funds rate to zero and introduced massive quantitative easing. Hence, the Fed surely had learned the lesson from 2008 – when R* drops below zero it is not enough to cut the policy rate to zero – quantitative easing (money printing) is also needed.

The swift policy reaction from the Fed certainly worked – the US economy rebounded strongly as did financial markets.

The recovery was so impressive that I in May 2020 in a blog post argued that US unemployment would drop to 6% by November 2020. When I made that forecast US unemployment was at 15%. My forecast turned out to be nearly right – we got to 6.7% in November 2020.

The swift recovery let me to start thinking that the Fed would soon have to revise it policy stance and start hiking interest rates and undoing quantitative easing and that was very much driven by what I observed in terms of the development in R* relative to Fed’s actual policy.

This was also very visible in the graph above. We see that R* bottomed out around April 2020 close to -4%, but in months following that we saw R* increasing quite fast and by the end of 2020 R* was back to zero.

This would imply that the Fed would have ended its quantitative easing by the end of 2020 and have started interest rate hikes already in early 2021. And this is in fact what I thought the Fed would do – or at least start a process of “normalization”.

As I wrote back in my original R* blog post in February 2021:

“This means that we in 2021 are likely to see the Fed being forced to change its message quite a bit. I am tempted to say that this smells of the stop-go policies of the 1970s and even though the outcome is likely to be less catastrophic than during the 1970s we could very likely see an increase in financial market volatility as a result of this.”

But the Fed did not change its message. Hence, in early 2021 Fed chairman Jerome Powell, again and again, stated the pickup in inflation was temporary and in July 2021 Powell now famously stated the Fed did not even think about thinking about hiking interest rates.

If we compare this to our model for R* we see that by the summer of 2021 R* had increased to 4% – indicating that by the summer of 2021 US monetary policy had become extremely easing.

In fact, if we look at the difference between the actual Fed funds rate and R* – what we could call the R-gap – then this is the easiest US monetary policy has been since 1974. It therefore hardly should have been a surprise to anybody that we would see a sharp spike in inflation in 2021-22.

Hence, the R-gap is telling us the exact the same story as the P-star model – US monetary policy became excessively in 2021 and this is the main reason why we saw a sharp pickup in inflation in 2021-22.

Said in another way we got into 2022 the Fed was way behind the curve and there was a very urgent need to initiate monetary tightening. The Fed started signaling this in October-November 2021 and then initiated the rate-hiking cycle in 2022.

As we see from the graph above R* basically levelled off around 5% in mid-2020 and since then the gap between the actual Fed funds rate and R* has been closing as the Fed has continued to hike rates.

And with the expected rate hike this week from the Fed we are now very close to having closed the gap between the Fed funds rate and R* and it is safe to say that based on the R-gap US monetary policy is now close to being neutral.  

Next: Fed will start cutting rates as inflation comes down

The Fed got way behind the curve in 2021, but during 2022 the Fed has been fast catching up and based on our analysis above is clear that the Fed likely will end its interest rate hiking cycle in the near future.

The next question becomes when the Fed will start cutting interest rates and here we can also get a bit of guidance from our R* model.

What we essentially need to do is to make a forecast for R*, which to an extent gets us into endogenous problems – hence if the Fed keeps Fed funds too high for too long then inflation will drop faster and economic activity slow, which both will push R* down. On the other hand, if the Fed cuts rates too fast then it will cause inflation to come down at a slower pace and economic activity will be higher, which will push up R*.

This, of course, illustrates on of the problems with a policy of interest rate targeting – it is to a large extent a process of trail-and-error and given how much out of whack US monetary policy has been it is easy for the Fed to err in this process.

But on the other hand it is probably reasonable to assume that the Fed eventually will get it right – and bring inflation down towards 2%, while keeping unemployment close to its structural level (NAIRU). If we use this as input in out R* we can simulate a scenario for the Fed funds rate in the coming years.

This is what I have done below. In terms of inflation, I have used our P-star model from my previous blog post to make some assumptions for the development in inflation in the coming years. My base scenario for inflation is a simple average for the two inflation scenarios (“hawkish” and “dovish”) in my previous post.

The graph below shows the simulated Fed Funds rate, which we assume follows R*, based on our assumed scenario for US inflation going forward.

This is no doubt a very benign scenario where inflation comes down back to the Fed’s 2% inflation target gradually over the next couple of years and the Fed funds rate is cut gradually to reflect the drop in inflation.

There is of course a lot of room for mistakes and as such, it is very hard to make anything else than a conditional forecast for the Fed funds rate going forward. That being said given that I expect inflation to start declining rather significantly in the coming six months it is also clear that we are very close to the end of the hiking cycle and eventually the Fed will start cutting rates.

The Fed most definitely will not get it perfectly right, but I am actually somewhat more optimistic that the Fed will manage the next ‘stage’ of this episode better than what it did in 2021 so my ‘best estimate’ is that by 2025-6 we would probably see the Fed funds rate around 1.5% – more or less at the level we hade during the period 2015-2019.

Finally compared to market pricing the scenario above is not significantly different from market pricing. Hence, the market expectation is also for the Fed to initiate rate cuts during 2024, and even though my simulations are actually indicating that we could get rate cuts already in the second half of 2023 given the rather large uncertainties this is not a major difference. Note here that this is not because I assume the US economy will fall into recession – in fact, I have assumed it will not.

The overall conclusion is that while the Fed clearly erred on the overly easing side in 2021 and did right in tightening monetary policy during 2022 we are now entering a period where we have risks on both sides and the Fed can and likely will err in both directions in the coming 1-2 years.