Interest rates have skyrocketed, but old rules of monetary policy suggest they have much further to go

Bank of Canada Governor Tiff Macklem addresses a news conference June 9 in Ottawa.PATRICK DOYLE/The Canadian Press

Central bankers have shocked stock markets and homebuyers with big interest rate hikes in recent months, but policymakers are still way behind where they should be in the battle to control inflation, following some simple rules of monetary policy.

A venerable guide to policy-making, known as the Taylor rule, suggests that the Bank of Canada and the US Federal Reserve should currently set interest rates near 9 percent. A broad set of rules from the Federal Reserve Bank of Cleveland isn’t quite as strict, but it still suggests that central bank rates should be around 3.9 percent.

The interest rates proposed by the rules are far higher than the interest rates prevailing in reality. They underscore the possibility that interest rates may need to go higher and stay there longer than most investors and homeowners are now anticipating.

Deciphering the Bank of Canada’s outrageous rate hike

Admittedly, monetary policy rules aren’t necessarily any better at assessing complex economic conditions than the people who actually run central banks. People start with the same data as the rules, but can also apply their own assessment of a complex situation.

In contrast, rule-based approaches reflect a rigorous analysis of facts against numbers. This is more limited than human decision-making, but also less prone to misjudgment.

For now, the rules say central banks have a lot of catching up to do as they try to quell the biggest burst of inflation in decades.

The Bank of Canada surprised markets earlier this month with an outsized hike of a full percentage point, but the move still kept the bank’s policy rate at just 2.5 percent. With inflation at 8.1 percent, real interest rates remain well below zero.

In the United States, the Federal Reserve has set interest rates at 1.5 to 1.75 percent. It is widely expected to hike interest rates by 0.75 percentage point after its July 27th meeting, but that would still leave it pretty much where the Bank of Canada is now.

In both countries, monetary policy is far below the level that would prevail if interest rates were set by automatic rules. These rules dispense with human judgment and only consider cold, hard economic data.

John Taylor, an economist at Stanford University, developed one of the first such rules back in 1993. Other economists have since proposed their own rules. Their approaches differ in details, but most reflect similar concepts.

They often start with the idea that there is a neutral interest rate that would keep inflation stable over the long term in an economy operating at full capacity. They then add up to that rate if inflation is above target. They reduce it when the economy is operating below potential, with high unemployment or other untapped resources.

Differences in the way models deal with these various factors can result in a wide range of recommended interest rates. The Cleveland Fed maintains a site that tracks seven simple monetary policy rules. The Federal Reserve monitors five rules. There is no consensus as to which rule is best or how closely policymakers should follow it.

What is clear, however, is that central bank interest rates are currently well below what most rules would suggest. In its monetary policy report to Congress a month ago, the Fed acknowledged that the five rules it followed mandated interest rates of 4 percent to 7 percent in the first quarter of this year.

Such high rates seem unimaginable to most people at the moment. Futures markets suggest investors expect both the Bank of Canada and the Fed to end their cycle of interest rate hikes at around 3.5 percent early next year and then quickly begin cutting rates as inflation eases and the economy is slowing down.

However, the rules may not be as far off the mark as most people seem to think. Some observers are already warning that interest rates will need to rise higher and stay higher for longer than futures markets expect.

Joseph Zidle, chief investment strategist in wealth manager Blackstone Inc.’s Private Wealth Solutions Group, told Bloomberg this week he expected the Fed’s interest rate to rise above 4 percent. He said he wouldn’t be surprised if it got close to 5 percent.

Similarly, Roberto Perli, head of global policy at investment bank Piper Sandler, argued in a note this week that anyone expecting quick rate cuts as a recession looms is likely to be disappointed.

Inflation is now at its highest level since the 1980s, he argues, and controlling inflation remains the Fed’s top priority even if the economy begins to weaken. For this reason, it is difficult to make comparisons with the Fed’s past behavior during periods of slowing economic activity.

“We’re not saying the Fed would ignore the fallout from a recession — it certainly wouldn’t,” Mr. Perli wrote. “But we say that the Fed’s response to a recession that is accompanied by high inflation and a tight labor market will be much more delayed and slower than in the past.”

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