Guest Contribution: “The Federal Funds Rate: FOMC Projections, Policy Rule Prescriptions, and Futures Market Probabilities from the March 2024 Meeting”

Today, we present a guest post written by David Papell and Ruxandra Prodan-Boul, Professor of Economics at the University of Houston and Economics Lecturer at Stanford University.

The Federal Open Market Committee (FOMC) maintained the target range for the federal funds rate (FFR) at 5.25 – 5.5 percent in its March 2024 meeting and, in the Summary of Economic Projections (SEP), continued to project a range for the FFR between 4.5 and 4.75 percent by the end of 2024. In contrast with experience through December 2023, futures markets summarized by the CME FedWatch Tool on the day following the meeting were in accord with the FOMC projections and also predicted a range for the FFR between 4.5 – 4.75 percent by the end of 2024.

There is widespread agreement that the Fed fell “behind the curve” by not raising rates when inflation rose in 2021, forcing it to play “catch-up” in 2022. “Behind the curve,” however, is meaningless without a measure of “on the curve.” In our paper, “Policy Rules and Forward Guidance Following the Covid-19 Recession,” we use data from the SEP’s from September 2020 to December 2023 to compare policy rule prescriptions with actual and FOMC projections of the FFR. This provides a precise definition of “behind the curve” as the difference between the FFR prescribed by the policy rule and the actual or projected FFR. In this post, we analyze four policy rules that are relevant for the future path of the FFR, update the policy rule prescriptions through the March 2024 SEP, and include futures market predictions.

The Taylor (1993) rule with an unemployment gap is as follows,

where  is the level of the short-term federal funds interest rate prescribed by the rule,  is the inflation rate, is the 2 percent target level of inflation,  is the 4 percent rate of unemployment in the longer run, is the current unemployment rate, and  is the ½ percent neutral real interest rate from the current SEP.

Yellen (2012) analyzed the balanced approach rule where the coefficient on the inflation gap is 0.5 but the coefficient on the unemployment gap is raised to 2.0.

The balanced approach rule received considerable attention following the Great Recession and became the standard policy rule used by the Fed.

These rules are non-inertial because the FFR fully adjusts whenever the target FFR changes. This is not in accord with FOMC practice to smooth rate increases when inflation rises. We specify inertial versions of the rules based on Clarida, Gali, and Gertler (1999),

where  is the degree of inertia and  is the target level of the federal funds rate prescribed by Equations (1) and (2). We set  as in Bernanke, Kiley, and Roberts (2019).  equals the rate prescribed by the rule if it is positive and zero if the prescribed rate is negative.

Figure 1 depicts the midpoint for the target range of the FFR for September 2020 to March 2024 and the projected FFR for June 2024 to December 2026 from the March 2024 SEP. Figure 1 also depicts policy rule prescriptions. Between September 2020 and March 2024, we use real-time inflation and unemployment data that was available at the time of the FOMC meetings. Between June 2024 and December 2026, we use inflation and unemployment projections from the March 2024 SEP. The differences in the prescribed FFR’s between the inertial and non-inertial rules are much larger than those between the Taylor and balanced approach rules.

Figure 1: The Federal Funds Rate and Policy Rule Prescriptions. Top panel: Non-Inertial Rules; Bottom panel: Inertial Rules.

Policy rule prescriptions are reported in Panel A for the non-inertial Taylor and balanced approach rules. They are much higher than the FFR in 2022 and 2023 and are not in accord with the FOMC’s practice of smoothing rate increases when inflation rises. In contrast, the policy rule prescriptions for 2024 through 2026 from the March 2024 SEP are consistently lower than the FFR projections. The inertial rules in Panel B prescribe a much smoother path of rate increases from September 2021 through September 2023 than that adopted by the FOMC. If the Fed had followed the inertial Taylor or balanced approach rule instead of the FOMC’s forward guidance, it could have avoided the pattern of falling behind the curve, pivot, and getting back on track that characterized Fed policy during 2021 and 2022. Looking forward, the FFR projections from the March 2024 SEP are very close to the policy rule prescriptions through December 2026. The current and projected FFR is in accord with prescriptions from inertial policy rules.

It has been widely reported that market participants have been predicting a steeper downward path for the FFR than the FOMC. This is illustrated in Figure 2, which depicts the median predictions from futures markets described in the CME FedWatch Tool on February 1, 2024, the day following the January 2024 FOMC Meeting, through the end of the CME prediction horizon in December 2024. The futures market predictions fall below the projected FFR from June 2024 through December 2024. This is described in more detail in our February 9, 2024, Econbrowser post.

Figure 2: The FFR, CME FedWatch Tool, and Policy Rule Prescriptions in December 2023. Top panel: Taylor Rules; Bottom panel: Balanced Approach.

Futures markets are no longer predicting a steeper downward path for the FFR than the FFR projections. Figure 3 depicts the median predictions from futures markets described in the CME FedWatch Tool on March 21, 2024, the day following the March 2024 FOMC Meeting, through the end of the CME prediction horizon in September 2025. The markets are completely in accord with the FOMC, as the futures market predictions are identical to the FFR projections. The change from December 2023 to March 2024 is entirely due to the change in the CME predictions, as the FFR projections through December 2024 are unchanged. The markets have caught up to the Fed and not vice versa.

We add to this discussion by including prescriptions from policy rules. Figure 3 shows that, for both the Taylor and balanced approach rules, the prescriptions from the inertial policy rules for March 2024 through December 2025 are close to the (identical) FOMC projections and CME predictions. In contrast, the prescriptions from both non-inertial policy rules are considerably below the FOMC projections and CME predictions for the same period. Comparison between futures market predictions and policy rule prescriptions depends on the choice between inertial and non-inertial rules but not on the choice between Taylor and balanced approach rules.

Figure 3: The FFR, CME FedWatch Tool and Policy Rule Prescriptions in March 2024
Top panel: Taylor Rules; Bottom panel: Balanced Approach.

This post written by  David Papell and Ruxandra Prodan-Boul.