A simple Fed "behind the curve" template can provide context for a discussion on what the Fed needs to do to get back to a neutral policy that is consistent with long-term inflation and growth objectives. We look at the MPS (monetary policy stance), the Taylor rule using the inputs form St Louis Fed president Bullard, and the inflation rate above target. We also include the shape of the yield curve on the front-end and the expectations embedded in the Fed funds futures.
The MPS is equal to the real Fed fund rate minus r-star which we estimate given other studies as being approximately .5. The MPS is minus 5% when in a normal environment it should be above zero. Clearly, the Fed stance is not hawkish or restrictive on inflation.
The Taylor Rule is modified to account for a very conservative estimate based work from the St Louis Fed. Again the result suggest that rates should be a lot higher. If we assume that the 2-year rate gives a forward estimate of what the market expects, there still is a further Fed increases necessary albeit the gap is less than what would be given using current Fed funds.
The inflation numbers are all above the target level and actually moving away from 2%.
The estimates for the Fed funds futures for December suggest that the Fed has to raise rates 175 bps to just be consistent with market expectations. This is also consistent with the difference between current and 1-year forward eurodollar futures and the spread between 2-year Treasuries and current EFFR.
So when asked, "Is the Fed behind the curve?", you can place some context and numbers with that statement.
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