By Paul Gomme and Peter Rupert
On July 25 the BEA announced that the advance estimate of real GDP increased 2.8% in Q2 on an annualized basis. The gains were fairly widespread, except for residential and non-residential structures, that fell 1.4% and 3.3%, respectively. Personal consumption expenditures, PCE, increased 2.3% and was the largest contributor to overall growth, at 1.57 percentage points.
PCE price index
On July 26, the BEA announced that the personal consumption expenditures, PCE, price index increased 0.95% on an annualized basis. Our preferred trend measure came in at 1.9%.
The Fed’s preferred measure, the PCE ex food and energy came in at 2.2% on an annualized basis while our trend measure came in at 2.6% and has continued to fall for the last 5 months.
As we have mentioned many times before, we believe our trend measure better captures the path of inflation and, more importantly, implications for Fed policy. For example, the annualized monthly change was higher in June, 2.2%, than in May, 1.5%. It seems pretty obvious that the Fed will not change its current stance on policy given this one month blip.
Policy Discussion
No doubt, there will be a lot of chatter about whether the FOMC should lower the Fed funds rate at its July 30-31 meeting, or wait until September. Or something else. To wade through all this, it helps to have a framework to organize thoughts about the incoming data. Arguably, the so-called Taylor rule has the broadest acceptance in the economics-policy profession. Briefly, the Taylor rule says that the Federal funds rate should be set as: (a) the natural real interest rate plus (b) the target inflation rate (2%) with (c) an upward adjustment when actual inflation exceeds target and (d) a downward adjustment reflecting slack on the real side of the economy. Typically, this slack is measured by either the output gap, or the unemployment rate gap. It’s easiest to understand why one of these gaps is included in the Taylor rule by thinking about what happens when there’s a negative gap. In the case of the unemployment rate, the idea is the demand for labor is high. Consequently, either firms will have to offer higher wages, or workers have more bargaining power and can command higher wages. Either way, these nominal wage channels put upward pressure on prices through some sort of “cost push” channel. This could be as simple as firms pricing using a constant markup over their (marginal) costs. In the case of a negative output gap, the story is that demand is outstripping supply, and firms find it easier to raise their prices. Returning to the Taylor rule, the idea is that these gaps reflect future inflationary pressures, and that the FOMC should respond now to head off future inflation.
There’s a lot of wiggle room in the Taylor rule. First, one needs an estimate of the natural real interest rate. The Atlanta Fed’s Taylor rule calculator provides eight (8!) choices for the real interest rate, currently ranging from 0.7% to 2.5%. That said, a given measure of the real interest rate does not change much over time.
Second, how to think about the deviation of inflation from target? As mentioned above, we like our trend measure which has moved down in 2024. The Taylor rule would, then, prescribe a lower Fed funds rate. But that prescription depends on the FOMC having religiously followed the Taylor rule over the past few years — which it almost certainly hasn’t. Nonetheless, some commentators may suggest that it’s time to start lowing the Fed funds rate since PCE inflation has come down in 2024.
Third, how to measure real-side slack? The output gap is given by potential output less actual output. The problem here is the nebulous concept of “potential” output. The fact that FRED has a potential GDP series is of no comfort. (“Fake data!”) To be absolutely clear, the output gap is a made-up number. Similarly, the unemployment rate gap is the difference between the “natural unemployment rate” and the actual unemployment rate. Some may substitute NAIRU (the non-accelerating inflation rate of unemployment) for natural unemployment rate, but it’s the same basic idea. As with the output gap, there’s the problem of measuring the natural unemployment rate. (“More fake data!”) Between the output gap and the unemployment rate gap, the Atlanta Fed provides 18 (yes, 18!) measures of real-side slack. What’s does the Taylor rule say should be happening with the Fed funds rate based on recent real-side data? Currently, estimates of the output gap are positive: there’s slack in the economy which tends to push down the Taylor rule’s prescription for the Fed funds rate. The strong growth in the second quarter is likely to cut the size of this gap (unless of course, potential output is revised!) which calls for a higher Fed funds rate. On the other hand, the unemployment rate has increased, and so the unemployment rate gap has increased which, through the Taylor rule, would call for a lower Fed funds rate.
TLDR: Inflation is coming down; the Taylor rule dictates a lower Fed funds rate. The output gap has narrowed; raise the Fed funds rate. The unemployment gap increased; lower the Fed funds rate.
So, here is the rub, even with the most widely used model at hand, it offers little guidance as to what to do next. Indeed, there is way too much wiggle room to come to a coherent and consistent policy recommendation.
