Fed funds rate as you see has moved in line with

first_img Fed funds rate, as you see, has moved in line with predictions for about two decades now. The Taylor rule suggested that the rate should turn negative in 2009, and the Fed kept as close to that suggestion as possible—by keeping it near zero. Now, even though for the past three years inflation has been lower than the Fed’s target, Bernanke’s calculations suggest that the Taylor rule-based rate has been creeping up since 2009. It is now in the positive territory to the tune of a little over 1.5%, but Bernanke’s successor hasn’t called for a hike yet. Of course, there is no reason to think that Janet Yellen has been looking at this same chart; and there is no reason to believe that the relatively simple Taylor rule (or any rule) should even be used for an economy as complex as the United States. However, it looks as though we are reaching a tipping point: a major decision will need to be made, and data is appearing that supports one course of action: a hike. So far, however, the Fed has been listening to the market. It’s not rigidly following a formula, however academically well-respected it is. And the usefulness of the Taylor rule is widely debated, by the way. The Fed’s ability to listen to what the market is ready to face gives me hope that, if there is a rate hike, it will be based on real-life data, not ever-changing theories. P.S. The theme of “Book” vs. “Novelty” came from an excellent podcast that I recommend to our readers, called Radiolab. The specific episode is called “The Rules Can Set You Free.” You can download it for free here. Even though the notorious CPI (the all-items version of it that includes food and energy) has crossed the 2% mark twice since April 2012, both PCE measures stayed well below it as the chart shows. Looking at this data, it’s clear why the Fed hasn’t raised rates. Weak GDP numbers don’t spell an immediate hike, either. But what’s in the bigger picture? One useful tool for understanding where the “optimal” interest rate should be is the so-called Taylor rule, named after the economist John Taylor of Stanford University. The Taylor rule takes in the actual vs. targeted inflation rate, deviation of GDP from trend, a “neutral” rate, and returns a federal funds rate that would either stimulate the economy or cool it down if it’s overheated. The Federal Open Market Committee, chaired by Janet Yellen, looks mostly at PCE as its inflation gauge of choice. So it makes sense to see where the Taylor rule predicts the fed funds rate should be. Fortunately, former Fed Chairman Ben Bernanke just shared some first-hand experience-based insight. In his recent blog post about the Taylor rule, Bernanke calculated the “appropriate” interest rate with PCE as the inflation gauge and produced this chart: People have been playing chess for a long time. Millions of games have been played, but they haven’t all been unique: some patterns proved effective, and players recycled them over and over. Thus, “The Book” was born: a recorded history of chess games for everybody to learn from. But in many games, most often in high-level championships, there comes a moment when the game goes “out of book,” meaning the players’ moves are unprecedented. Professional players describe the feeling of going from “The Book” to “The Novelty” as surreal: there is no established knowledge to support either you or your opponent anymore, no lifeline. You are alone together, staring into the abyss of unexamined possibilities. That is exactly how the business of forecasting feels. The brightest minds in our industry are struggling to predict the next rate hike. Some say it’ll come as soon as June, some point to the end of this year, some say low rates are here to stay. Econ 101 suggests we won’t see a hike soon: inflation is too low. Not the consumer price index (CPI) that we all love to hate but hits peer, PCE—personal consumption expenditures index. PCE is what the Fed uses to gauge the prices consumers face. And it has stayed well below the Fed’s 2% target for three years in a row: both PCE and core PCE, which excludes food and energy, hit 2% in April 2012 and have not touched that level since.last_img