Friday, September 14, 2007

It is pointless to resist

A fair amount of virtual ink has been spilled debating whether the Fed will cut on Tuesday. Most of it has centered around the sub-prime mess and consequent liquidity crunch. I've argued in this space that the Fed would work to provide liquidity to the bond market, and in fact they have, by lowering the discount rate and expanding availability of discount window borrowing.

Anyway, there are many who still believe the Fed shouldn't cut on Tuesday. I've seen many solid arguments for this case. Some revolving around inflation, which is an argument I find appealing, but ultimately incorrect. Others are focused on moral hazard, which is a case I understand and am to which I'm sympathetic, but still I find unconvincing.

But the case was strong for a Fed cut before the liquidity problem really got going. But don't listen to me, ask John Taylor, devisor of the well-known Taylor rule. As with many ingenious ideas, the Taylor rule is a very simple model. It postulates that monetary policy is basically a function of two things: GDP growth and inflation. That's not much of a stretch. Then you assume that the proper Fed funds level is a function of the difference between GDP growth and potential GDP as well as the difference between current inflation and target inflation. The classic Taylor rule calculation assigns a coefficient to these two gaps and adds them together. Subsequent economists have concocted any number of alterations. Discussion of a few can be found here. Anyway the classic formula is as follows:

R + B1(y - Y) + B2(p - P)

Where B1 and B2 are constants, y is actual GDP growth, Y is potential GDP, p is actual inflation, P is target inflation and R is the base rate. You might think of R as the intercept.

The Taylor rule has done a pretty good job explaining Fed activity in the past, although its ability to predict Fed activity into the future is mixed. Some use this fact to damn the model's usefulness, but I disagree. The fact is that in order to use the Taylor rule into the future, you have to predict the model's inputs. In other words, to predict what the Fed might do 4 quarters from now, you also need to predict GDP and inflation 4 quarters from now. Not too easy. Frankly the data is too damn variable, even the revisions to CPI and GDP can be quite large. But if you want an idea about how tight/easy monetary policy is right now, the Taylor rule is a great guide. If you have a good idea of how tight policy is now, you can make a reasonable forecast as to where the Fed is most likely headed.

Anyway, let's look at the GDP gap.

Note that the estimation of potential is my own. I think that any estimate of potential GDP would be considerably higher than that 1.9% year-over-year growth the economy turned in last quarter.

For inflation, I use the Cleveland Fed's Median CPI measure. My research shows that this is most accurate for use in the Taylor rule. And I assume the Fed's target is 2%. That's broadly consistent with recent Fedspeek.

Inflation remains above the target, but the trend is obviously lower.

By my estimation, the Fed should cut rates down to the 3.75% area based on current data. Will this happen? Historically, this model is pretty accurate in guessing whether the Fed would hike or cut, but not much accuracy on the degree. Again, I think this has a lot to do with the variability of the data. But it also has to do with how Fed activity today impacts the future. If I think current conditions warrant 3.75%, it may be that the Fed cuts to 4.50% and that alone causes inflation or growth to tick up. So instead of putting a lot of weight in the estimated level, I interpret the 3.75% signal as indicating a strong likely hood of more than one Fed cut.

So you can agree or disagree with my case, but anyone in the "Fed Cut = Sub-Prime Bail Out" camp should realize that there is a very reasonable and classic macro economic argument for several Fed cuts right now. I think the liquidity crunch merely closes the blast doors on a September cut.


Anonymous said...

TDDG - I generally agree with your postings, but have to voice my strong disagreement with you on this latest post. First and foremost, you should make is clear that YOU very much have a vested interest in a Fed cut, as the rest of the investment management community. If the Fed's do not cut, you can kiss whatever decent YTD performance your portfolio may have had goodbye. For hedge funds, in particular, who are levered up to Uranus, their very survival is dependent on rate cuts to further inflate the markets and effectively bail them out of their current slump. Inflation concerns are real and the matter of moral hazard is legitimate. If people in this market want to take on bad risk, they should also pay the price when those investments turn sour. You know why TDDG? Because in the past few years, those same managers who levered up on everything and/or ventured into risky and opaque investments posted spectacular returns, they were deemed investment savants and were paid very handsomely at year-end. It is not the Fed's responsibility to bail out people who take on bad risks. It is their responsibilities to maintain pricing and monetary stability. The spectacular bull market and gushing liquidity of the last few years were the by-products of Greenspan's ill-conceived aggressive rate cuts and we are currently experiencing the ramifications of his policies. Yes, no rates cut may very well lead us into a recession (and perhaps threaten our very jobs), but when what-was a robust economy was effectively fuel by artificially cheap credit and spawn unsustainable growth, a correction is absolutely what an efficient market needs. Greenspan’s rate cuts after the boom spawn this current credit crisis, another series of rate cuts will not only delay, but exacerbate the inevitable – a very painful correction.

Accrued Interest said...

Well I'm actually positioned better for higher rates than lower rates, so I can't say that I'm a benficiary of rate cuts. Even if I were, what the hell would that matter? I'm pretty sure Ben Bernanke doesn't read accrued interest.

I've said a fair amount on the moral hazard issue and I respectively disagree. I also think you have to be realistic about what the Fed WILL do versus that you think they OUGHT to do. I think there is overwhelming evidence that the Fed WILL cut rates in the face of a recession.

Anonymous said...

I don't understand the argument that we have to "pay" for the lower rates in the past with a recession now because otherwise the rich greedy hedge fund guys who made money will "get away with it." Who freaking cares? If you want to make the argument that lower rates will cause inflation, then fine, that's an argument I can accept. But moral hazard arguments sound like sour grapes from those who didn't cash in.

If rate cuts can stave off recession without being inflationary, then who cares who gets "bailed out"?

Anonymous said...

You know what… you are right, Alan. Who cares about the fundamental strength of the economy? Ever heard of the business cycle? Non-sensicial crock! I propose that after these series of rate cuts, which will ultimately delay an inevitable painful correction, we again cut rates all the way down to 0 when a market crisis re-emerges. If that doesn't work, we should all work with our legislator to cut tax rates all the way down to 0 to further inflate growth. Who cares about sensible and sustainable sources of growth and productivity? As long as we can artificially inflate the market to grow FOREVER, our lives will be better off. You on board Alan? And oh yeah, I don't mind paying $100 bucks for a Big-Mac or that sink-hole on my drive to work… as long as my levered-up-the-wazoo portfolio keeps posting those exuberant returns. Thank you Alan and thank you Ben Bernanke!

Accrued Interest said...

Alright... let's all simmer down now. I agree with Alan's point that the Fed should be focused on economic growth and inflation, not on punishing hedge funds. I don't think there is a strong case that inflation remains a major problem right now.

Anonymous said...

Newsigma, please read my comment more carefully. I specifically said that the inflation concerns are valid, but your over-the-top statements and claims of a final catastrophic correction smack of the ultra-bear nonsense we've been hearing for the past 20 years. I can still remember that book "The Great Depression of 1989" by Ravi Batra and the annual updates in 90-92 when his predictions never came true.

Anonymous said...

Fair enough. All I'm saying is the case for not raising rates because of inflation is strong. Anecdotally, where I live, inflation has been a b*tch. We've seen cost of everyday food like a Big-Mac rise 15-20% YoY (I know, silly example, but very indicative of the state of inflation in my city). I actually work on the fixed-income trading desk and can say nearly all my colleagues also support rate cuts and have actually already positioned their portfolios for such an event on Tuesday. But... when I hear their rationale, they all surreptitiously cover the true reasons of why they sponsor a rate cut – that is, the market will tank and we will see a severe credit crisis: this is obviously bad for our business. Why I don't support a rate cut when it is obviously beneficial for our desk? Because I believe a credit market re-pricing and stock market correction is what we need to strengthen our economic fundamentals for the LONG-TERM, especially when face with real and serious inflationary pressure as we current do. Any market turmoil as a result of no cuts…. Well, those are the consequences of over-leverage, speculation and irrationality. And Alan, NO, I am not an ultra-bear, nor am I an ultra-bull.

Smurfy said...

This Taylor rule based line of thought would have been valid even at the time of the last fed meeting. But Bernanke didnt act on it then. Why now?


Anonymous said...

What coefficients are you using for your Taylor Rule estimate?

venkat said...

Based on the graphs that were posted (Ignoring the recent trends in both GDP and Inflation), it looks to me like a classic case of stagflation. In such a scenario, what is going to be the Fed’s priority? Inflation or GDP growth.

You did mention that you find a downward trend in inflation and consider that the Fed should follow an expansionary policy. The GDP graph also shows a slightly upward trend which obviously is a tricky situation for the Fed. I am assuming that the target rates of inflation and GDP that you have used are more or less similar to those the guys at the fed have in mind.

Considering the recent inflationary trends in China which obviously will have a direct effect on the US CPI, what would be Bernanke’s first priority? Though the GDP growth has been less than desired, unemployment numbers seem to be fairly under control which is one more reason I think the Fed might not go for a drastic cut in interest rates.

I neither gain nor lose directly from Fed’s actions and as an impassioned observer; I feel that the Fed has enough reasons to not go for a rate cut. It might reduce the discount rate if the situation becomes bad and might go for a rate cut only if the situation becomes desperate. Feel free to correct me.

venkat said...

Btw, I just wanted to add that those were some passionate responses form Newsigma and Alan. I won't conceal that I enjoyed reading these well constructed and spicy arguments.
ttdg, thank you for bringing out the best in so many people. Keep up the good work.

Anonymous said...

all, the feds funds rate has been cut already...just go to and put in a search from 7-1-07 thru 9-13-07 or any time period will see that as of 8-10-07, the effective feds fund rate avg is 5.00 and all data prior was at or around 5.25...They just have not announced it which tells you tons about the integrity of the Federal Reserve in the first place...This should be on every newsmedia right now but it is not...

Anonymous said...

An interesting article about John Taylor and the current interest rate environment;_ylt=ArWkxiuzoKdC0zue4XOaBAcE1vAI

Anonymous said...

sorry... all one link

Anonymous said...

I hope Bernanke raises rates. This bubble needs to be squashed rather than extended.

Did everyone miss Greenspan admitting he was completely wrong to lower the FFR? FFS, why would anyone repeat his blind stupidity? At least Volcker has the class to say "No comment" each time he's asked his opinion.

The world economy is healthier than the US at this point. Lower rates and you get capital flight. Also, how can you justify lowering rates when all current economic indicators are positive? Oops!

Anonymous said...

"it also has to do with how Fed activity today impacts the future. If I think current conditions warrant 3.75%, it may be that the Fed cuts to 4.50% and that alone causes inflation or growth to tick up. So instead of putting a lot of weight in the estimated level, I interpret the 3.75% signal as indicating a strong likely hood of more than one Fed cut."[tddg]

Thanks for this, Mr. T, it was very helpful.

Assuming B1 + B2 = 1.0, mainly cuz its the only way it makes sense to me, I get a rate cut to 4.5% if one weights a change in GDP almost as important as a reduction in inflation to 2% (B1 = 48%, B2 = 52%). Thats using your numbers, of course.

Is this why you wrote "there are many who still believe the Fed shouldn't cut on Tuesday. I've seen many solid arguments for this case. Some revolving around inflation, which is an argument I find appealing, but ultimately incorrect."?

Plugging in my own p = 3.5% and P = 1.5% (midpt. between 1% and 2% inflation), I get no change in Fed Funds Rate if I almost equally rate an increase in GDP (B1 = 49%) to a decrease in inflation rate (B2 = 51%).

I wouldn't have presented my thinking this way without the benefit of your post. Thanks.

Accrued Interest said...

Couple of points here. Thanks all for commenting even if I can't get to responding.

Some notes on my Taylor Rule model: I built it as a trading tool, so its intentionally early. As to my coefficients, the one for inflation is much larger than GDP. Many academic articles focus on getting the Taylor rule to correctly predict the exact level. My own work in that area indicates that somtimes improving the model's accuracy in the short-term diminishes the model's usefulness as a trading indicator.

Venkat: All else being equal, I think the Fed's emphasis on inflation is much stronger than GDP growth. I've written on this several times. (such as this from exactly a year ago:

Now here is something interesting to ponder. If the Fed is so anti-inflation, why didn't they keep hiking as inflation kept rising in 2006? Because they were worried about the housing market. So in my mind, they already have altered their normal course because of the housing market.

To Anon who says the Fed as cut already, bingo. We talked about this in August.

NewSigma: Thanks for the link.

Accrued Interest said...


Taylor's original work suggested 0.5 for both B1 and B2. So your estimation would be right on Taylor's original model. My coefficients don't equal 1.

The specification of the inflation target is a challenge. I picked 2% because I believed if GDP were at potential and inflation was at the top of their "comfort zone" they wouldn't hike rates to bring it down. That's a bit of a supposition on my part, but the model works well with that as the target.

Can you explain what you mean by the coefficients have to equal 1 or it doesn't make sense to you?

Accrued Interest said...

After thinking about it for approximately 14 seconds, here is my thought on coefficents = 1. The larger the size of your coefficents, the more aggressive the Fed will be about "correcting" the imblance. So say your coefficients are 0.5 and 0.5. If inflation gap is 0 and GDP gap is 1%, and the Fed is currently at equalibrium, the model will suggest a 50bps cut.

If you set your coefficients to 2 and 2, then the same scenario suggests a 200bps cut.

So I don't think they have to add to 1.

Anonymous said...

TDDG, why did Fed Funds close today at 5.375%, per Bloomberg (USSW)?

Anonymous said...

"So say your coefficients are 0.5 and 0.5. If inflation gap is 0 and GDP gap is 1%, and the Fed is currently at equalibrium, the model will suggest a 50bps cut.

If you set your coefficients to 2 and 2, then the same scenario suggests a 200bps cut.

So I don't think they have to add to 1."[tddg]

Mr. T.:
In your hypothetical scenario of Inflation Gap = 0, GDP gap = 1%, I can only hope that the FOMC would easily reach the conclusion that the GDP gap is all important and Inflation is of little concern, so they would agree that B1 = 1.0 and B2=0.

I started to explain more and found my comment inflating to one of the comments in this blog.

Please be patient for my response until I can reduce it to a manageable size.

Anonymous said...

According to Robert Hetzl of the Richmond Fed, an inflation coefficient of less than one can be blamed for the '70's.

He estimated

i = 1.5 + 1.56π + .62x + ˆμ

for Greenspan, 8/87-5/99.

At Jackson Hole, Taylor used 1.5 (inflation) and 0.5 (output)

Anonymous said...

Hell. This is the ref for Jackson Hole.

flow5 said...

Rationale: The "trading desk" has "mopped up" the bulk of excess legal reserves (see total legal reserves) and asset-backed commercial paper has started to rebound. Note that CP is the second largest money market instrument next to Treasury Bills. Companies continually re-cycle the preponderant, shortest duration, maturing securities. If companies were unable to float/issue new paper in the money markets, it would be obvious to the market participants well in advance.

Towards the end of the reserve maintenance period (the last week ending 9/12/07) the “trading desk” allowed the fed funds rate to spike at over 6%+ on 3 consecutive days. This lead to banks borrowing $7.3b in funds from the Fed’s discount window at the lower primary credit rate of 5.75%.(not a penalty rate, rather a potentially, profitable rate). It should be obvious that the FOMC has directed the "trading desk" to "mop up" the excess legal reserves injected in the week ending 8/15/07 - stemming from extraordinary funding to distressed depository institutions, and from the money markets systemic stresses. This is clear evidence that the FOMC intends to get “back on track” and to resume its’ “tight” monetary policy. It will otherwise have a more difficult time with stagflation next year.

Don't see a recession but there will be a short sharp downturn. The FED needs to support the dollar, minimize inflation, & maximize employment & tax receipts. Real estate appreciated over 80% in 5 years, let prices fall.

The "policy rule" is ex-post. Monetary flows are ex-ante. Markets & the economy bottom in Oct.

Anonymous said...

Priority #1: "Can you explain what you mean by the coefficients have to equal 1 or it doesn't make sense to you?"[tddg]
I hope I never breach the fine etiquette of this blog by ever saying something "has to" (insert here).

Priority #2: It turns out my calculations above were based on a arithmetic error I made. I calculated GDP gap to be -2.1%. I have now mastered subtraction, and discovered that 1.9% - 3% is -1.1%, not -2.1%. (aside: the calculations above are still good if potential GDP = 4%).

"Assuming B1 + B2 = 1.0, mainly cuz its the only way it makes sense to me"[psychodave] was intended to communicate
a) how I arrived at the subsequent calculations
b) any misconceptions of mine you might care to address

I did not use any regression to arrive at (B1 + B2) = 1. I had two unknowns, and one equation. To get anywhere (I am native to this planet, unlike some I know) I needed a second equation. (B1 + B2) = 1 suited my purposes and I could improvise theoretical foundation later.

@james: Thanks for the link showing Taylor himself citing a B2 of 1.5, I stand educated.

There's still a lot I don't know. When tddg hypothesized a Fed Funds Rate of 3.75%, I could not conceive of a rate cut (-1.5%) larger than the GDP Gap (-1.1%).

@flow5 Do you still anticipate a low in interest rates in October?

Anonymous said...


Is there any evidence that fine tuning works? Never mind, don't answer that -- emprical proof is overrated.

But you have to admit its a lot squishier than Taylor makes it out to be: policy lags, secular forces, open economy and FX, risk aversion, real return expectations -- all of these introduce uncertainty into the fine-tuning process. That doesn't mean fine-tuning doesn't work (although I do hold that opinion), it just means that the degree of confidence placed on it by market participants is WAY overdone.

Another way of saying it: the "fine-tuning works" bet is perhaps the most crowded trade since the internet bubble.

flow5 said...

@psychodave: Do you still anticipate a low in interest rates in October?

Yes & weakness should be showing up now. This about math, but good theory also helps. I say it's impossible to miss economic forecasts. That may be hyperbole, but Dr. Leland James Pritchard's (Ph.D, Chicago 1933) equation hasn't failed in 94 years. The downside is that, since 1996, it's not been possible to tell the magnitude of any move - because the FED discontinued the G.6 release.

Anonymous said...

TDDG - thanks for your blog. even when debates get a little heated, the arguments are still well reasoned and thought out.

I have to question why you focus on CPI (any variant) for inflation? Housing (was) going up 15% per year, health care is still going up 8-10% per year, food is up 6-7%, crude oil and gasoline are up double digits. And yet the BLS continues to say CPI is between 2% and 3%? CPI clearly does not reflect the price levels paid by real people. Are you a monetarist? M2 is up 8% yoy. Private groups that attempt to calculate M3 claim it is up 13% yoy (I take the M3 numbers with a big grain of salt, but M2 is from the Fed). How about looking at the USD forex rates? EURUSD is hitting all time highs. Any way you cut it, CPI is nonsense -- meaning any "inflation" argument based on it is ...

I also wanted to challenge your use of the other half of the Taylor Rule. The model requires you to assume a potential GDP rate-- to decide if we are above/below potential. Now, according to Taylor himself, Greenspan set rates way too low for 3-4 years (2001-2005 ish). Hence, there was huge incentive to borrow from the future to spend in the present-- so some of the GDP "potential" for 2007-2008 was borrowed against and shifted into those earlier years. Hence, your assumption about current GDP potential is overstated -- vastly IMHO. We overbuilt houses that had zero economic feasibility, and its now going to take a year or two to absorb that excess inventory. Given housing's import to the economy, GDP potential should be marked much much lower. In short, there is no GDP "gap".

Skimming news articles, you see company after company has excess cash and is returning it to shareholders as higher dividends and/or share buybacks. If there were great business opportunities for this money, why not invest it in those opportunities? Why is Warren Buffet sitting on $40 billion if there are great opportunities? Answer: there aren't any investments that make economic sense. Lowering rates to make credit more available makes no sense. If you are a "good credit risk", there is plenty of money available. If you are a "bad risk", that's where you have a problem. But a bad risk is still a bad risk at a lower FF rate -- it just bleeds to death a little slower.

Anonymous said...

One other point I should have mentioned about using CPI to estimate inflation for the Taylor Rule: Taylor made the rule (using CPI) way way back in time. Specifically, before Michael Boskin and friends decided to change CPI. CPI today is not the same as CPI when Taylor made his rule

Accrued Interest said...

David Pearson:

Touche on the fine tuning. Greenspan himself once said that he wished there was no Fed at all. But if we're going to have one, he thought the way he ran it was the right way. For the moment, it seems as though he steered us right, but should this sub-prime problem continue to spread, I think history will wind up blaming the Fed for creating it.

Accrued Interest said...

On CPI: I use Median CPI, which takes all of the CPI components and uses the median rate of change as the generalized inflation level.

On potential GDP: Certainly its an estimate. I don't think you'll find much variation in estimates for potential GDP though. If anyone knows of an economist who pegs potential output at something subtantially different than 3%, let me know.

flow5 said...

"M2 is up 8% yoy. Private groups that attempt to calculate M3 claim it is up 13% yoy)."

The M3 reported by Nowandfutures is an exact reproduction of the Fed's old number.

However, there is considerable double-counting in the Fed's monetary aggregate M2, & M3 is mud pie.

The volume of money is unknown & unknowable. In 1980 the DIDMCA commingled our depository institutions and added 38,000 commercial banks to the 14,000 we already had.

And no monetary aggregate standing alone is adequate to explain rates-of-change in real-gdp or rates-of-change in inflation (which should incorporate food, health care, transportation, housing, etc., in its index/target).

Interest rates will fall even if the FOMC doesn't lower the fed funds rate. And hopefully the FOMC won't.

"Did everyone miss Greenspan admitting he was completely wrong to lower the FFR?"

At 2%: The crux of the cause of our monetary mismanagement, especially since 1965, is the assumption that the money supply can be managed through interest rates, specifically the federal funds rate. We should have learned the falsity of that assumpt8ion in the Dec. 1941-Mar. 1951 period. That was what the Treas. - Fed. Res. Accord of Mar. 1951 was all about. The effect of tying open market policy to a fed. funds bracket is to supply additional (and excessive legal reserves ) to the banking system when loan demand increases. Since the banks have no excess reserves of significance the banks have to acquire additional reserves to support the expansion of deposits resulting from their loan expansion. If they use the federal funds market, which is typical, the rate is bid up and the fed responds by putting through buy orders, reserves are increased and soon a multiple volume of money is created on the basis of any given increase in legal reserves.

Anonymous said...

How much of a factor does the impact of a cut on the value of the dollar play in the Fed's decision and your analysis? Next to inflation, I worry about our dependency on outside investment.

I also think the moral hazard argument is a strong one. It is not about punishing those who took on risk believing that they could pass it on or be bailed out, but making it clear to future investors that risk must be assessed.

Anonymous said...

They cut rates and the 10-year yield went up. Oops! Capital flight has begun, and as usual, the middle class is fubar'd.

National debt? Who needs monetary policy when we've got these nifty printing presses!

Accrued Interest said...

I feel like we're all beating this moral hazard thing to death. I just don't think anyone at any of the hedge funds that have fallen apart ever thought the Fed would bail them out. So it never came into their decision making. Furthermore, those hedge funds have already blown up and nothing the Fed is doing now is going to help. I'm telling you, sub-prime MBS are dead. Period.

Anyway, I think the dollar is complicated. The classic way of looking at currencies is in terms of interest rate differentials. If rates in the US are relatively low, then the dollar will fall, because capital will seek out the best rates. That's all that's going on right now. Rates are much better in Europe than the U.S. At least, that's my read. I don't think we have a real capital flight. If we do, that's a pretty big problem. So hope that we don't. I haven't seen any indicators that we're going through a capital flight though.