Fed returns to its 1990s reaction function

The Fed’s hawkish transformation has been so marked that, if its forecasts are to be believed, over the next couple of years it would effectively be adopting the same reaction function last followed during the Greenspan and Bernanke eras between 1987 and 2008. We find that hard to believe, however, since the still-muted pace of potential economic growth means that the natural interest rate remains well below 1990s levels. The upshot is that, despite the current tough talk from Fed officials, the markets are right to expect the Fed to cut rates over the next couple of years.