Finite Portfolio Manager David Krestchmer is here to help you make sense of this abruptly volatile rate environment.
Analyzing the Fed’s recent decisions (or lack thereof)
A quick glance at the financial news reveals seemingly endless headlines on rising interest rates, and parades of views as to what the Federal Reserve should and will do. The wide range of opinions highlights the uncertain economic landscape in which we find ourselves; the fact that many well-informed people have such divergent views as to what the Fed should do, versus what they actually expect to happen, highlights a lack of trust in the Fed.
This distrust emanates not just from the Fed’s belated efforts to address rising inflation, but from the lack of awareness that their efforts were even needed in the first place (harken back to as recently as November 2021, when policymakers were still calling inflation “transitory”).
Since the Fed’s 25 basis point hike in the Fed Funds Rate in mid-March and the pronouncement that they are likely to raise rates in 25 basis point increments at each meeting (but holding off shrinking the balance sheet for the moment) for the rest of 2022, it has become clear to many market participants (and even some Fed governors) that more decisive action is necessary. This raises at least two questions regarding the Federal Funds Rate; what should it be, and how fast should the Fed move to get it there?
Regarding the rate itself, bookends would be Cathie Wood of ARK fame, who tweeted earlier this month that the Fed should leave its rate target where it is, at 25 to 50 basis points.
On the other end we have the Taylor Rule, which would put the ideal rate at roughly 9.3%. The center mass of the discussion appears to fall within the 2.0% to 3.0% range, but don’t be surprise if the conversation shifts in coming weeks.
The Cathie Wood angle would seem to be the proverbial “talking her book” as she’s fairly alone on an island with her position. As we’ve witnessed increasingly since February of 2021, rising rates aren’t good for growth company stock prices, because those whose valuations rest on projected future earnings get discounted at higher rates.
As we doubt that even Cathie expects the Fed will entertain her “advice,” it seems more like a hedge such that as rates rise and the share price of $ARKK falls (at least in the short term), she can say “not my fault; I told you they shouldn’t have raised rates.”
Enter the Taylor Rule
In stark contrast to Cathie’s position, we have the Taylor Rule. It’s a formula authored by Stanford economist John Taylor, fairly simple in its math but more complex in its intention; some limit its usefulness to a description of what the Fed has done in retrospect, while many others consider it a prescription for what the Fed should do in the immediate future.
Despite its success as a positive economic tool (its ability to describe the current state of the world is highlighted in Graph 1 below) it is clearly neither positive at the moment nor normative (a description of the world as it should be) for the Fed as would it take over thirty-seven 25 basis point increases to arrive at what the rule deems as “neutral.”
Graph 1. Sources: St. Louis FRED, Bloomberg
Graph 2. Sources: St. Louis FRED, Bloomberg
Whether viewed as positive or normative, the basic Taylor Rule formula is:
r = i + R + .5(i - i*) +.5(y – y*)
Where:
- r = the Fed Funds Rate
- i = the actual inflation rate
- R = the targeted real rate
- i* = the targeted inflation rate
- y = real economic measure (GDP or measure of unemployment)
- y* = the target for that economic measure (either GDP or unemployment)
In plain English, the Fed Funds Rate should start with the inflation rate plus the targeted real rate, then subtract a premium for the inflation gap (how far the actual inflation rate is below the targeted rate), and another premium for the output gap (how far the economy is from some targeted measure of economic activity). Taylor used GDP versus potential GDP; with the Fed’s stated focus on employment this variable has generally evolved to be some measure of the rate of unemployment less an actual rate of unemployment.
While debates can go on as to defining each of the variables (i.e. which inflation rate: CPI, core CPI, personal consumption expenditures, etc) we’ll stick with the default options in Bloomberg*. Plugging in their base case scenario we get:
r = 5.4% + 2.0% + .5(5.4 – 2.0) + .5(4.0 – 3.6)
r = 9.3% (Fed Funds Rate per the Taylor Rule)
In a neutral world, in which there is no inflation gap and no output / employment gap, the rate would be 4% as the 2% real rate and 2% inflation rates are generally accepted targets and the gap premiums would each be zero. But in the real world in which we live today, where inflation is printing at a 5.4% (and higher depending on your definition of inflation), employment actually above target, and the Fed Funds Rate upper end at 50 basis points, the questions become, what does the Fed do, and how fast do they do it?
How could the Taylor Rule influence upcoming Fed decisions?
The rate is of course, as announced, going up. And after previous pronouncements of 25 basis point incremental increases, orthodoxy seems to have evolved to 50 basis point hikes, at least for the next couple of Fed meetings. Thus, upward movement. But what does such a large Fed Funds gap imply (the gap between the Taylor Rule rate and actual rate)?
Negative real rates are inflationary, so even though the Fed is raising rates, inflation will continue, even possibly accelerate, until the Fed Funds Rate and the Taylor Rule rate converge. This doesn’t necessarily mean the Fed should move to 9.3% immediately. The Fed Funds gap is volatile as can be seen in the graph above, and policymakers must operate in the real world in which some degree of consistency with signaling is important. The Fed has begun talking more hawkishly in recent days (an effort to mitigate inflationary expectations), signaling more decisive action.
To be clear, the Fed is capable of decisive action. Paul Volker took office in August 1979, a year in which the Fed Funds rate averaged 11.2% and raised it to 20.0% by June of 1981, decisive and quickly successful as inflation fell from 14.8% to under 3.0% in under two years. While inflation isn’t as problematic today, this does give a sense of how aggressively the Fed can act when faced with the need to get the Fed Funds Rate meaningfully above the rate of inflation.
Graph 3. Source: St. Louis FRED
Takeaways
The take-home message is that the Fed is not just far behind – but very far behind – in the battle against inflation from a Taylor Rule perspective, and will need to move assertively to raise rates. The rate market is quickly coming to a similar conclusion as the yield curve has flattened and even inverted recently.
Mortgage rates now exceed 5%, floating rate loans will be adjusting meaningfully, and bond prices will continue suffer. The good news is that as rates rise, inflation is quelled, and opportunities for savers and investors to be compensated for lending will be realized after years of near-zero rates. Getting from here to there, however, will be a bumpy ride for fixed income markets.
* The Bloomberg base / default case actually comes to 10.7%. We’ve made two changes to the Bloomberg assumptions; first, we stay with Taylor’s scaling of 0.5 times the inflation gap whereas Bloomberg defaults to 0.85; we also excluded an option for the Okun factor, which scales the output gap by a factor or 2; taken together these result in a Fed Funds target of 10.7% rather than the 9.3% at which they’ve arrived.
