Fed Is Ignoring Actual Inflation Data

Federal Reserve policy makers tend to believe temporary shocks account for the persistent undershooting of the inflation target. But there's a more disturbing possibility: Central bankers might just be using a broken model of inflation. Given that risk, they should pay attention to actual inflation and lean toward passing on a December rate hike. Nonetheless, they are prepared to move forward. The dismissal of actual data given these very real concerns about the forecasting accuracy of the Fed’s models could place us in a more dangerous stage of the business cycle.

The Fed uses a monetary policy rule as a guide to setting short-term rates. Policy makers focus on Taylor-type rules, which make policy a function of the neutral interest rate (otherwise known as “r-star”), the central bank’s inflation target, deviations in actual inflation relative to the target, and deviations of unemployment from its natural rate.