Should rates be higher or lower than current levels? Many can provide narratives associated with reasons for rates moving in either direction. The phasing will go something like this, "rates have not priced in all of the inflation we are seeing", or "rates should be pricing in the chance of sooner Fed action, therefore...". To some degree, these are just guesses. If rates are falling, then the weight of market opinion is changing toward lower inflation expectations. If rates are rising, the opposite is occurring. To provide some concrete value decision, we need to have some valuation model that can get into the specific for why rates should be higher or lower.
The Atlanta Fed provides a nice Taylor Rule tool that can be used to estimate what could be the equilibrium rate. They provide more than one specification for the Taylor Rule and the investor can change the weights. There is no "feeling" about rates but some specifics that can be debated based on the model and input assumptions.
The conclusion from looking at a number of specifications is that rates should be higher based on the modeling provided. Of course, Taylor Rules have been suggesting negative rates during the pandemic and have also pointed to higher rates over the last decade. The Taylor Rule, as a valid tool, can be questioned, but it provides a foundation for discussion. The Fed is not following numbers or past policy. It is targeting inflation at higher level and looking to close all of the output gap from excess unemployment. Under more normal conditions rates should be rising but we are far from normal.
This discussion at least generates a focus for valuation. we will continue this discussion with a look at r-star and the NY Fed term premium model in another post.
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