Powell Rules

There’s a new kid in town. Jay Powell’s first major speech as Chair of the Federal Reserve, the Monetary Policy Report to Congress, had an immediate impact on markets, interpretated as indicating a more hawkish stance than his predecessor. Time will tell but one interesting feature of his speech was his emphasis on monetary rules in setting policy, which  he finds ‘helpful’, with an analysis of five such rules detailed in the Report.

It seems clear that the Fed do not slavishly follow any rigid precription in setting interest rates, although the rate paths implied by the various rules  are apparently set out ahead of FOMC meetings in order to act as a guide, and Powell’s speech is likely to stimulate further market interest in this area.

The best known rule is named after John Taylor , and posits that the Fed funds rate should move by precribed amounts from its long run equilibrium level  ( which on current FOMC forecasts is 2.75%) if inflation differs from the 2% target or if the real  economy  has moved away from its full employment level, which the Fed currently believes is consistent with an unemployment rate of 4.6%.

What does the Taylor rule imply now? The Fed expect inflation in 2018 to pick up to 1.9% but that the unemployment rate by the final quarter of the year will have fallen to 3.9% and so below the long-run equilbrium level , indicating that tighter policy is required, with an implied  Fed funds rate of 3.3%, which is around 1% higher than the median FOMC expectation as set out in the ‘Dot Plot’.  In other words rates would rise more rapidly than curently envisaged by the market , although over the following few years the ‘Dot Plot’ converges to the Taylor rule, albeit with the latter implying a modest easing of policy while the former points to a steady tightening. The Taylor rule also implied the need for negative rates following the financial crash and an “Adjusted Taylor rule’ take account of this insufficient monetary accommodation in the past by advocating a gradual return to the rate implied by an unadjusted Taylor rule, although the former has now largely converged to the latter.

What of the other rules discussed? A ‘balanced Approach’ rule gives a greater weight to deviations from full employment and that also indicates that policy is too accommodative, and indeed should be much tighter by end-year, with a Fed funds rate of 4%, before falling back to 2.75% in the long run.  Not all rules imply the Fed is behind the curve, however, with the other two rules discussed arguing against aggressive tightening. One, the ‘First Difference rule’ takes account of the current level of the Fed funds rate and the pace at which unemployment is changing, and implies a policy rate of 1.75% by end-year, which is below the ‘Dot Plot’ figure . Similarly, another variant, ‘the ‘Price Level rule’, implies that policy is also too tight now and as projected because the rule adjusts for the fact that inflation has been below the 2% target for some time, so the price level is therefore lower than would be the case had inflation been at 2% every year.

All such rules are based on simplified models of complex  and changing dynamics in the US economy, but ,as Powell noted, can be useful for policy makers . Three of the five imply that rates are too low given the Fed’s expectations for inflation and unemployment which may prove more significant with Powell at the helm.

 

The Fed, Policy Rules and Market rates

It is a long time since the US Federal Reserve last raised rates ( in June 2006, from 5% to 5.25%)  and one has to go back over a decade to find the start of a tightening cycle (in June 2004, from 1% to 1.25%).Consequently there are many in the financial markets who have never  experienced a period of rising interest rates although that may be about to change, judging by rate expectations; the Fed Funds rate is currently trading at 0.12% ( the Fed’s target is 0-0.25%)  and the futures market is pricing in a strong probability of a rate rise over the late-summer and autumn this year.

Of course the Fed itself has also changed tack in terms of monetary policy, in response to the improvement in the real economy, including strong employment growth and a decline in the unemployment rate. Consequently the FOMC terminated its asset purchase programme last year and has now dropped its forward guidance on rates, indicating that the decision will now be data dependent. That does not mean that a rate rise is inevitable ( some FOMC members are worried that inflation is low and may not pick up as anticipated)  and the exact timing is clearly debateable, but what is interesting is the divergence between the market’s rate expecations over the next few years and that indicated by the published views of the FOMC.

One standard method of predicting the future path of Fed policy is using the Taylor rule, first put forward in 1993. The original  formulation  envisaged an equilibrium Fed funds rate of 4%, with the Fed adjusting policy if growth moved away from trend or if inflation deviated from target (assumed to be 2%). A popular variant of the model uses an empirical relationship between unemployment and economic growth (Okun’s law) to derive a rule which includes the unemployment rate  as a proxy for full employment instead of GDP or

r = 1 + 1.5PCE – (UR -URF)

where r= the Fed funds rate, PCE is the annual inflation rate ( the Fed prefers the consumption deflator to the CPI) , UR is the unemployment rate and URF is the rate associated with full employment

We can use such a model to project the Feds fund rate implied by the latest forecast made by the FOMC members(based on the  central tendency). That envisages the unemployment rate falling to 5.25% by the fourth quarter of 2015, and as such around the Fed’s idea of full employment ( an unemployment rate between 5.2% and 5.5%). The FOMC expects inflation ( at 1.3%) to remain below target this year but to  move up to just under 2% by 2017, and based on those forecasts the Taylor rule implies a Fed funds rate of 2.9% at end-15, 3.9% at end-16 and 4% in 2017.

Indeed, the rule indicates that Fed policy should have been much tighter at the end of last year ( around 2%) . The severity of the Great Recession and the sluggish nature of the economy have persuaded central bankers that this time is different, however, and Janet Yellen, in a speech in June 2012 *  put forward reasons why policy should remain looser for longer and discussed two alternatives to the Taylor rule as outlined above.

The first , a Balanced rule, doubled the weight on the unemployment variable. This did imply a different rate trajectory given the level of unemployment at that time but such a model now shows little difference from the basic Taylor rule, because  the unemployment rate  is so close to full employment- the  path of  the Fed funds rate is virtually identical in the two models.

Yellen went on the put forward a third approach – optimal control. This involves using a range of Fed funds rate in a model of the US economy  in order to minimize a loss function, with the latter set in terms of the deviation of unemployment and inflation from target levels. That approach did imply a longer period of zero rates and a slower tightening cycle, albeit  also rising to around 4% in the medium term. We do not know what that optimal control approach states now but based on the charts published in the Yellen  paper  it may imply a Fed funds rate of 1.25% by end-15 and 3% by end-16.

The Fed will not slavishly follow any model in setting policy and the data may disappoint but what is striking is the divergence between market rates and that implied by any of the three models if the fed ‘s economic forecasts are broadly right. For example, 3- year bond yields are currently trading at 1% with the 2-year at 0.63%, which implies a 1-year rate in two years time of 1.7%. If the market is wrong in its implied pessimism on inflation and growth  there is a very big bond market accident waiting to happen.

* Yellen, ‘Perspectives on Monetary Policy’ , Federal Reserve, June 2012