A simple Fed action framework

With the discussion on whether the Fed raises rates heating up, there has been renewed activity with watching its every action and every macro announcement, yet there is almost too much information to process. A simple Fed action diffusion framework can be a disciplined approach to determining whether the Fed is to "go" or "no-go" with raising rates. We use a framework to just classify or gather data in a structured form. This framework classifies data and then will add a marker on whether a key input variable is going higher or lower.

We start with the famous Taylor Rule, but apply some simple adjustments. The Taylor Rule describes Fed activity through three factors, inflation, the output gap and equilibrium interest rate. Many have tried to employ it as a forecasting tool, but with the zero bound its usefulness has been limited. It was a good representation of Fed activity until the Financial Crisis. Nevertheless, the  rule will come back into style as the Fed moves off the zero bound. We believe it has a use for classifying what fundamental information will impact the variables used in the Taylor Rule.  

We tie all economic information into five categories which are embedded in the Taylor Rule:

1. Inflation based on the PCE, the preferred measure of inflation by the Fed;

2. Output gap, where can be proxied by the unemployment rate versus NAIRU;

3. The equilibrium real rate which is usually set at a constant of 2% but can be adjusted;

4. A new factor - A market stability uncertainty index. This accounts for the third goal of the Fed - macro stability;
5. The international effects - other central bank behavior, foreign interest rates, and the dollar.

The framework we use looks at two additional factors which we think help focus discussion on the next Fed action.

A market uncertainty or macro stability factor which the Fed is supposed to account for though Dodd-Frank. We believe that any increase in market uncertainty or macro instability will cause the Fed to delay actions. Call it a cautionary factor. If there is more instability relative the  average, there will be a lower interest rates set by the Fed.

The fifth factor we look at is the international environment which has been missing from the original Taylor Rule. Of course, the Fed in general has not placed a lot of stock on international events except in a crisis. We believe that there is a short change in thinking and a greater desire to account for the policy of other central banks. A strong dollar or monetary policy that is out of step with the Fed may likely cause policy behavior that eliminates these differences or forces rate behavior that is consistent with full employment. Policy coordination in a post-crisis world is more important. In this case, the rising dollar may be a drag on employment which should delay Fed action. Similarly a dollar shortage will have negative impact on emerging markets which will affect trade which again will affect full employment.

Now to focus discussion on rate changes, we do not estimate a new Taylor rule, but set a diffusion index for each factors to determine if there is a tilt in the data that will increase the likelihood of action to raise, lower, or maintain rates.  This is a disciplined qualitative measure. We will look at each major factor and determine whether the direction support Fed action or a delay. Here is our current readings:

INFLATION -       DELAY - All inflation indicators below 2%
OUTPUT GAP -   DELAY - Slowdown in first quarter and general flatness in growth
EQ RATES -         DELAY - Equilibrium rate using SF Fed model suggests below 2%
STABILITY -       DELAY- Higher stability readings from Fed banks
GLOBAL -           DELAY - Asian and EM slowdown; other central banks easing.

Overall, we do not see any reason to take near-term action to raise rates. Our qualitative measure does not give any indication that market forecasts are late. We think the bias is for delay relative to any market indicator like the Fed funds.