It’s amazing how much time the press and investors spent analysing the wording used by the FOMC in its latest monetary policy statement and how seriously they tried to extract the degree of dovishness from Janet Yellen’s face in the press conference that followed. Everybody was angrily looking for clues about the path that interest rates will take in the near future while the high-frequency trading bots were trying to rip risk-free profits in nanoseconds just by searching for specific words as “considerable time” in the FOMC statement. While this non-sense occurs, no one is really concerned about looking at the real numbers for the US economy, those that in the end will determine the course of action the Fed will have to take. Such is the paranoia these days that it is rather easy for traders to be caught in erratic market movements, with the Dow inverting from panic selling to panic buying in a matter of minutes. Last Wednesday was one of those days, with the Dow being inspired by the Fed’s statement. Speaking for myself alone, I have to admit that I couldn’t find the reason why traders pushed the equity market so high following the FOMC announcement. Perhaps they found something that I didn’t.
Unlike the hierarchical mandates that determine policy action at the BoE and the ECB, the Fed is bound by a dual mandate requiring a double concern. At one side lies price stability while at the other lies economic growth and stability. While both mandates lead to similar equilibriums in the longer-term, the Fed can specifically tackle short-term deviations in growth and employment from their natural long-term values. This means that the Fed may very well justify a cut in its key rate to accommodate an economic downturn, even if that means allowing for an inflation rate above the central bank long-term level set at 2% – provided that it occurs only temporarily.
In 2008, the Lehman Brothers collapse led to a liquidity squeeze, panic selling, recession and deflation. According to its business model, which is mostly based on its dual mandate and the Neo-Keynesian models on which it bases rate decisions and intervention, the Fed had no other option than to lower the base rate until reaching the minimum possible level of zero (even though that is no longer the minimum, it appears). With zero rates being insufficient to prevent deflation and economic contraction, the Fed engaged in quantitative easing to expand its balance sheet and to provide liquidity to the market in excess of what was required in order to maintain near-zero interest rates. The main idea was to boost asset prices and decrease borrowing costs to seduce more investment in order to create more jobs and reflate the economy. The situation was so bad that Ben Bernanke even introduced a conditional commitment making an interest rate hike dependent on a target unemployment rate of 6.5%.
But if we look at the numerical data that has been released, it is undeniable that the situation has changed drastically. The unemployment rate is now at 5.8% – i.e. well below the conditional level set by Bernanke. At the same time, other job market indicators have been pointing to a decent recovery. Just look at the non-farm payrolls for November, for example. The number released points to a 321,000 rebound in jobs during the month. Data for initial unemployment claims has also been trending down with the headline number held bellow 200,000.
On one hand, the Fed has accomplished its task of stabilising growth and employment, as an unemployment rate of 5.8% is now very near to the NAIRU (non-accelerating inflation rate of unemployment) which is currently estimated to lie at 5.5%. But the real problem resides with the inflation rate, which has been systematically below the 2% target.
The Fed has been concerned with the effect a change in policy could have in the economy and therefore has been assuring investors that the interest rate would be kept unchanged for a “considerable time”. But as the job market is overheating, the Fed knows that something should be done very soon and they’re preparing investors for it. Nevertheless, the central bank is so concerned with the impact such inversion in policy may have in the equity market that its language has been all over the place, ranging from “considerable time” to “no hurry” and back to “considerable time”. But, as I said at the beginning of this article, I’m not writing to discuss the final effects of this absurd wording but rather to understand what is behind it.
Central banks now tend to base their decisions on a Neo-Keynesian model. One way or another, even if not too explicitly, they guide their decisions using Taylor’s rule, which is really simple to understand and can be expressed thus:
i = r + pi + 0.5 x (output gap) + 0.5 x (inflation gap)
The central idea is that when observed inflation is at the central bank’s target rate and the economy is growing at its estimated full employment level, the interest rate set by the central bank (i) should be equal to the long-term real interest rate (r) plus the observed inflation rate (pi), which in such an equilibrium case is just equal to the inflation target. Taylor estimated r to be equal to 2% for the US economy, while inflation targeted by the central bank is 2%. In long-term equilibrium, the Fed should therefore set its interest rate to 4%. When inflation rises above its long-term target and/or output rises above its full employment level, the central bank should increase its key rate. The reverse is also true.
What can we infer from Taylor’s rule?
One way of expressing Taylor’s rule in terms of an employment gap instead of output gap is by using an adjustment known as the Okun’s law, which states that we can use this equation instead:
i = r + pi + 2 x (NAIRU – unemployment rate) + 0.5 x (inflation gap)
The basic functioning is intact. Now, if the unemployment rate decreases below NAIRU (which is consistent with a situation in which output increases above its full employment level), the rule states that the central bank’s key rate should increase.
With the above in mind, it’s time to look at what has been done in the US so far and what is going to happen in terms of monetary policy in the near future.
I have collected data between January 2000 and December 2014 for all needed inputs in order to compute the interest rate that is advised by Taylor’s rule and compared it to the effective Fed funds rate. In order to fill the necessary inputs, I used the Personal Consumption Expenditures Price Index as the inflation gauge (others could be used as well with the final conclusions remaining intact); the civilian unemployment rate released by the BLS, as the unemployment rate; and the NAIRU long-term estimates published by the Congressional Budget Office. The inflation target and the real interest rate are both held at 2% across the years. The following chart compares the interest rate estimated using the above data with the effective Fed funds rate.
There are several important observations we can make after analysing the above chart. First of all, the Taylor rule suggests a negative interest rate between November 2008 and November 2013. During that period the employment and inflation gaps were so huge that the only way to induce a decline in real interest rates would be through negative interest rates. But, because of the zero lower bound, that could not happen.
But, do you remember what happened in December 2008, just one month after the Taylor’s rule suggesting a negative interest rate?
That’s right! The FED funds rate was lowered to zero and QE1 was announced at that month’s FOMC meeting. With no margin to use interest rates as an expansionary tool anymore, Ben Bernanke adopted non-standard measures, with QE being trick number one.
Now fast-forward to the point at which our Taylor’s rule states interest rates should start rising to positive territory. That occurs at November 2013. Remember what happened at the FOMC’s December 2013 meeting?
That’s right! Before leaving the FED, Ben Bernanke announced the end of QE3. There’s more than coincidence in all this. Even if the FED monetary policy does not follow rigid rules, it gets some guidance from Taylor’s rule.
The Taylor’s rate turned positive in November 2013 and started gaining traction in April this year. It currently sits at 2.6% while the effective Fed funds rate is still near zero. The employment gap is currently -0.3% (as the NAIRU is 5.5% and the civilian unemployment rate is 5.8%), and the inflation gap is -0.6% (as the PCE price index is 1.4% and the target inflation rate is 2%). Using the Okun’s adjusted Taylor rule, we get the 2.6% rate (or 2.5% due to rounding). Even if we consider a scenario where headline inflation is 0%, the Taylor’s rate would still advise a 1.4% rate, significantly above zero.
Putting all pieces together
Looking at all these data and having in mind the high correlation between Taylor’s rule and the effective funds rate, I would say that, at this pace and given its business model, the Fed won’t keep its key rate at this level for much longer. I expect the central bank to start hiking the rate at the end of Q1 or at the beginning of Q2. Unless there is an unexpected worsening of labour conditions, I expect the hike in rates not only to occur but also to be significant, as the Fed is already 250 basis points below Taylor’s rule level…