The US Federal Reserve has bet everything on economic recovery. Historically expansionary monetary and fiscal policies have pulled the US economy out of the pit in record time. But this rapid growth has been accompanied by a strong price boom (inflation) that in another era would have triggered several interest rate hikes. The famous Taylor Rule reveals that the Federal Reserve has fallen far behind the curve look where you look. Interest rates should be at a much higher point at this point in the cycle. The pressure for the body chaired by Jerome Powell ahead of its March meeting is total (the market is still betting on a rise of 50 basis points at once).
John TaylorProfessor of Economics at Stanford University, is a prominent economist who has earned much of his fame for having developed a formula in the early 1990s (known since as the Taylor Rule) to determine the appropriate interest rate to be charged by a central bank. The Taylor Rule describes the proper relationship between the official interest rate, the natural interest rate (the equilibrium rate), inflation, and the output gap. Right now, that rule and its subsequent amendments suggest that the Federal Reserve should tighten monetary policy.
The data is clear and conclusive. The inflation is at 7.5% (compared to the Fed’s 2% target), the interest rate unemployment has fallen to 4% (in line with Non-Accelerating Inflation Unemployment or NAIRU), vacancies unfilled are close to 10 million (yes, there are ten million job offers that do not find their match), the salaries rise at an annual rate of 5.7% (in recent decades they have not reached 4%) and the START is about to exceed its potential level, generating a positive output gap (the economy is about to start operating above its potential). All this jumble of data is consistent with an economy in dire need of a cold shower.
Taylor’s rule simulator Bloomberg establishes that the interest rates managed by the Fed should stand today at 9%, compared to 0.25% which marks the official price of money. The simulator shows how from the late 1970s (oil shock) to the mid-1990s, Fed interest rates exceeded even Taylor’s recommendation in an attempt to stifle inflation. Since then it has been more common to see official interest rates below the Taylor Rule, especially after the last financial crisis.
If the calculations of Bloomberg leave little room for doubt, those of one’s own Atlanta Federal Reserve they confirm it. The study service of this division of the central bank calculates the Taylor Rule with three different models and the three show that ideal interest rates should be around 7%. Of the three simulations, one places them at 7.55%, another at 7.5% and the lowest at 6.98%. If the first two have been calculated taking into account US unemployment, the third has been estimated with the GDP gap.
To perform these simulations, the Fed takes into account indicators such as labor conditions carried out monthly by the Kansas Fed. This indicator is at its highest point since April 2000, shortly before the bubble of the dot com In U.S.A. Up to 24 variables come into play in this data published by the Kansas Fed: requests for unemployment benefits, broad unemployment rate, hours worked, hiring forecasts for large companies… To all of the above is added in the formula the natural interest rate, the output gap or core inflation.
Analysts at Bank of America (BofA) Securities corroborate this same thesis. “Our US economics team has long argued that the Fed is lagging the curve, and we agree. The Taylor rule is a simplified metric for lagging the Fed, and it is interesting to compare it to previous cycles. Using a 0% real neutral interest rate and standard weights on inflation and the unemployment gap, this rule would imply a current policy target of 6.2% (Taylor using core CPI suggests 8%),” says the team of Ralph Axel, Mark Cabana & Bruno Braizinha.
“The current Fed policy stance implies the largest gap from Taylor’s rule since at least the 1990s. Even if inflation falls, as most expect, the Fed will have to tighten policy significantly. Taylor’s rule may overstate the exact amount, but based on historical comparison, a faster increase than the measured pace of 25 basis points per meeting from the 2004-2006 cycle seems warranted. We see elevated risks of a 50 basis point hike in March and/or May, given the very accommodative stance of current policy.”
“While we recognize the benefits of a gradual approach to hikes, the potential cost may be high if inflation surprises to the upside. The Fed is not surprised when it rises. Since the 1990s, the Fed has only gone up if the market has priced the odds at 60% or higher, and typically at 80% or higher,” these analysts stress before concluding that “the Fed will do anything possible to communicate the magnitude of the increase in March before the period of silence begins” prior to a meeting of the body.
An even more exhaustive calculation is made by the analysts of the Nordic entity Danish bank in a recent report. Analysts Mikael Olai Milhøj and Jens Nærvig Pedersen examine four different specifications of the Taylor rule: the original Taylor Rule, the Taylor Rule with inflation expectations rather than actual inflation, the Former Fed Chairman Ben Bernanke Rule ( greater weight on the output gap) and the Bernanke Rule with inflation expectations instead of actual inflation. With the four models the two economists conclude that the Fed is behind the curve.
In their methodological note, Danske Bank analysts clarify that they undertake the Taylor Rule including inertia; that is, taking into account that the Fed tends to apply monetary policy more gradually than suggested by the original Taylor Rule. Likewise, they take into account underlying inflation instead of real inflation to eliminate the prices of raw materials and food. This means that their results are not as high as in the cases of Bloomberg or the Atlanta Fed, but they continue to demonstrate the backwardness of the US central bank.
Milhøj and Pedersen find that “the Fed is already between 60 and 110 basis points behind the curve (60 basis points just looking at the current upper level of the 0.25% Fed funds target range and 100 basis points looking at the so-called shadow rate that tries to capture the effect of QE) when looking at the two rules with inflation expectations, since long-term inflation expectations have not risen as much as core CPI inflation.” “When you look at the two rules with core CPI inflation, the Fed is between 200 and 250 basis points above behind the curve”, they add.
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