The Bullard framework using the Taylor-Rule

The Taylor Rule can be employed to provide some precision in our thinking about the Fed's interest rate path. The market is constantly being bombarded with Fed governors, Fed presidents, and market pundits telling us what will or should happen to rates, but few reveal their model for generating their opinions. 

A recent speech by St Louis President Bullard provides a strong simple framework for the Fed rate discussion. The Taylor Rule can be used as a model for suggested future changes in rates. This is not a dynamic model, but it can provide an idea of what could be the terminal policy rate. See "Getting Into the Zone"

The Taylor Rule is a policymaking workhorse for suggesting the appropriate policy rate. It is problematic at the zero bound, but in the current environment it can be very useful. The Taylor Rule forecasts the effective policy rate by looking at a simple equation based on a few key inputs. The recommended policy rate will be a combination of the inflation target which is currently 2%, the neutral rate of interest, R-star, which is currently between -.5% and .5%, the output gap, which is currently zero, and the inflation gap between current inflation and the policy rate with a sensitivity variable usually set between 1.25 and 1.5.  

Bullard generates a generous and less-generous recommended policy rate path which can then be compared with current rates. The difference between the current policy rate and the Taylor estimate is a rate gap that will be needed to be closed. By measuring the inflation path through time, we can figure out how the gap will be closed, either a by a slowdown in inflation or an increase in rates. If inflation slows, we will reach the sufficiently restriction zone faster. If the inflation remains stuck near current levels, rates will have to be increased further. 

Playing with the input values will give us a good idea of what it will take to get to an appropriate rate level. Under this scenario approach, we can get closer to the right policy through a couple of rate increase combinations. If the PCE inflation stays stable, we can get to the lower bound or generous level through a 75 and 50 bps increase or two 50 bps and a 25 move. If we have a view that we want to reach the average value which is between the less and more generous number, we will need more increases. A 50 bps increase in December, 50 bps in February, and 25 bps in March will get rate into the bottom of the sufficiently restrictive zone.