Thursday, November 19, 2009

Taylor Rule: There's nothing for me here now

We've been talking a lot about the Fed lately so I thought I'd share my version of the Taylor Rule calculation. I've built this myself so it might not exactly track other versions that are out there, but I did follow Taylor's basic methodology. Bear in mind that this isn't meant to predict Fed Funds. I use it more as a reality check. If my Taylor Rule calculation is falling I'm not likely to make a call that Fed Funds is going to be rising.

Anyway, here is a recent chart of the output. Taylor Rule in green, actual Fed Funds target in blue. I took it out to 4Q 2009 assuming that 4Q GDP and CPI comes in equal to Bloomberg's economist survey (3%).

Holy liquidity trap Batman! Its sharply negative, suggesting that monetary policy can't get easy enough. Thus it justifies the Fed's current stance.

Now consider what it looks like if I carry out the Bloomberg median survey result for both GDP and CPI through 2010.


Suddenly the "correct" Fed Funds level according to my model is 2%, by the first quarter! Will the Fed actually hike by 200bps between now and 1Q 2010? Even assuming that GDP comes in as expected in 1Q, I highly doubt the Fed gets this aggressive. But could they start hiking? I think its possible.

I think readers should consider the following:

  • Potential GDP is probably falling due to a less levered economy. That means a lower level of GDP would be considered above potential and thus potentially inflationary. It probably also means a higher level of NAIRU.
  • There is room to remain accommodative in policy but be above zero on Fed Funds target.
  • The fact that we're far below trend GDP levels doesn't matter. In a Keynesian world, its a question of whether Aggregate Demand is outpacing Aggregate Supply. What Aggregate Demand would have been in 2006 isn't relevant.
  • As a trade, if GDP does improve but the Fed doesn't hike at all, then it will be time to put on a bear steepener!

32 comments:

Anonymous said...

i think it is time for you to do some more of the bond trading basics course, please.

how do you "put on" a bear steepener?
bull steepener? flatener?

Advant Guard said...

90% of economic forecasting past the current quarter is reversion to mean. It guarantees that you are wrong 99% of the time but it reduces your average error. The forecast for Q4 has some information in the but for all quarters past that it is all noise and mean reversion.

Remember, economic forecasting was invented so weather forecasting could look respectable.

getyourselfconnected said...

I think it is clear that these models are cool in a book but have zero relevance in the real world.

FED rate at 2% before 2012, or really 2013? Myth, like a unicorn.

Accrued Interest said...

Avant: I grant you every thing you say, with the exception that 4Q GDP isn't terribly hard to predict when you are in the middle of 4Q already. It won't be exactly 3% but I'd be willing to bet on a range of 2.5-3.5.

Connected: IF growth is in the 2.5% area in 2010, then the Fed will be hiking at some point. I'm not calling for 2% FF, I'm just saying its a possibility.

Gold prices said...

I don't think that 2% FF is possible. It is useless to even keep it in probability.

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Flow5 said...

You have to ask yourself if it really makes sense that economics is called the "dismal science".

It just means that your listening to the wrong prognosticators and their theories.

IORs @.25% induce disintermediation among the non-banks, or shadow banks, or financial intermediaries.

Member banks do not loan out savings. They create new money in the lending process.

Money flowing to the intermediaries (intermediary between saver & borrower), never leaves the monetary system (commercial banks). Money flowing to the intermediaries increases the supply of loan-funds, decreases long-term interest rates, matches savers with investment, minimizes inflation, etc., etc.

Keynes had it wrong & so do all of his diciples.

RB said...

This study came to a different conclusion.
http://econompicdata.blogspot.com/2009/11/where-are-long-bond-yields-going.html

Anonymous said...

AI -
Wow interesting push back on economic forecasting and the Taylor rule - almost seems as readers are saying "Your sad devotion to that ancient religion has not helped you..."

Do you think that the mid-term elections would play any role in the Fed's decisions ( I know, I know the Fed is totally independent..., but what if as Uncle Owen said "the wizard (Bernanke)is just a crazy old man?).

Also, given 0 rates and banks making monopoly money profits when does the political calculus kick in, I mean there are (at least in my mind) so many political ramifications of the interest rate decision (or maybe it just seems that are more than in the past...)

I really enjoy your blog and appreciate your taking the time to write - Hope everyone has a great Thanksgiving!

commoncents said...

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ps. Link Exchange?

leftback said...

Anon @ 1.01pm: re: "steepeners"

Gaze at yield curve.
Think.
Consider buying and selling at the ends.
Receive enlightenment.

AI: If the Fed hikes in 2010, it will be the first major departure from the Japanese playbook.... and the thing is, we all know that the GDP is fake, and consists purely of government intervention.

So we are stuck in a moment. Liquidity trap indeed.

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are all the bond bloggers being taken out by the treasury?

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