When the Federal Reserve speaks, investors listen, and they don't always like what they hear — especially when the message signals more tightening.
The stock market dipped Thursday after St. Louis Fed President James Bullard said in a presentation that more rate hikes are necessary to hit the central bank's target range of 2 percent inflation. "To attain a sufficiently restrictive level, the policy rate will need to be increased further," he said.
"Sufficiently restrictive" is the Fed's latest artistic term for the less-than-scientific process of deciding when the central bank's benchmark rate is high enough. As Bloomberg columnist Jonathan Levin argued in a recent op-ed, the phrase "exists to provide something that looks and feels like specific guidance, but is vague enough not to tie policymakers to a specific reaction function."
In other words, "sufficiently restrictive" is a moving target, and the Fed has a lot of discretion when it comes to settling on a number.
The Taylor Rule
Yet Bullard, who is known for sometimes breaking ranks with other Fed officials, is pushing for a more technical approach, one that happens to entail a more hawkish stance than many investors were anticipating.
Invoking the so-called Taylor rule — a mathematical formula for setting rates — Bullard argued that even with a "generous" view of monetary policy, a minimum rate of 5 to 5.25 percent would be necessary to curb inflation. Taking a less generous view, he said a 7 percent rate might do the trick.
The Taylor rule formula says the Fed should raise rates more than one-for-one with any increases in the inflation rate. So if core personal consumption expenditure — the Fed's preferred inflation measure — is at 5.1 percent, a 1.25 ratio would suggest a minimum of 5.25 percent.
This would be up from the current rate of 3.75 to 4.25 percent, which the Fed achieved through a steady clip of massive rate increases, including four consecutive 75-basis-point hikes in the second half of 2022.
However, some Fed-watchers take issue with the Taylor rule, and argue that it's not applicable to the current moment.
How to Use the Taylor Rule
Claudia Sahm, the founder of Sahm Consulting and a former Federal Reserve economist, said the Taylor rule is more "descriptive than prescriptive."
"When John Taylor originally published the Taylor rule, it looked at the Fed's policy decisions in the past," she said. "It was a simple way of explaining them. It wasn't about saying what the Fed should do."
The critique fits into a long lineage of fierce debates over what models the Fed should use to determine monetary policy. The Taylor rule, along with the Phillips curve — which looks at the relationship between employment and inflation — is among the most contentious.
Sahm is in the camp that says the Fed should use discretion when it comes to setting rates, rather than relying on single formulas and models.
She also stressed that it's a bad fit for the current variety of inflation.
"One reason that the Taylor rule is not appropriate is that a substantial portion of the inflation we have now is due to supply side disruptions related to COVID and [decisions by Russian President Vladimir] Putin," she said. "It's a type of inflation that raising interest rates is not well-equipped to address."
In addition, Sahm has been critical of Fed officials who offer up opinions that are counter to the consensus view while markets are so fragile.
"When he talks like that, he moves markets, and it is absolutely inexcusable," she said. "Why are you talking about 7 percent [interest rates] a week after a favorable consumer price index?"
Whatever information Bullard used to reach this view, the calls for more tightening contrasts with recent comments from other Fed officials, such as Vice Chair Lael Brainard and Board of Governors member Christopher Waller.
Both echoed Chair Jerome Powell's remarks that moderation could be coming soon.
“The data of the past few weeks have made me more comfortable considering stepping down to a (half-point) hike,” Waller said. “It is important to remember that this would still be a very significant tightening action.”