Taylor Rule and current policy - no change in rates

The chart is from the fine writers at Calculated Risk. The question of when the Fed will raise rates is consuming fixed income investors. There are some simple rules that can be applied to this discussion, past history of the Fed and the Taylor rule. Both of these suggest that we will have some wait before any action is taken. But there is disagreement on how long we will have to wait. For example, Morgan Stanley forecasts the Fed will start to increase rates in the second half of 2010 and be above 1% on the Fed Funds before year-end. Goldman Sachs believes the wait will be longer , until 2011.

There are two rules that could be followed. One is a simple timing rule. The Fed does not start to raise rates until unemployment has peaked after which there is a delay of approximately nine months. If unemployment peaks at year-end, we should see some Fed action in the fourth quarter. This scenario is actually fairly rosy. Of course, the credit easing programs could be cut before an actual rate increase.

While Bernanke has been negative on the economy in his latest speech, the Taylor rule can be used as a good proxy of what the Fed should do to rates. Here, I agree with Paul Krugman who states that the Fed has a long way to go before it tightens. Krugman also champions the Rudebusch version of the Taylor Rule which is easier to implement.

The Rudebusch version of the rule is:

Target fed funds rate = 2.07 + 1.28 x inflation - 1.95 x excess unemployment

where inflation is measured by the four-quarter change in the core PCE deflator, and excess unemployment is the difference between the actual unemployment rate and the CBO estimate of the NAIRU, which is currently 4.8 percent.

The original Taylor Rule is

FF Rate = 1 + 1.5 x Inflation + 0.5 x GDP gap

This is avery simple equation, but there are two merits in Rudebusch version over the original version:

1. Parameters are deduced from actual data, whereas parameters in the original version are rather ad-hoc.
2. Unemployment rate is more straightforward statistics compared to GDP gap.

These rules describe past Fed policy quite well, but if you plug in the numbers the Fed should be running deep negative rates. This was no expected when the rule was originally designed. The only way the Fed can get negative rates is if it inflates the economy. To achieve inflation in the domestic economy, the international financial community will have to see a further dollar decline.