Isn’t it Ironic? Taylors Rule & FED Rates — Macroeconomics
Alanis Morissette’s epic number might be the best song to hear when you decipher Federal Reserve chair Jerome Powell’s recent announcement of FED’s intention to keep interest rates status quo until 2024. The Federal Reserve’s recent announcement that it will not raise federal funds rate until 2024, marking the rate between 0 to 0.25 percent is at best perplexing. The following read on the Federal Reserve is not a critique of the Federal Reserve’s announcement but an attempt to understand the levers enabling the Fed Fund Rate.
The Federal Open Market Committee meets eight times a year to decide the rate. “The federal funds rate is the interest rate at which depository institutions trade federal funds (balances held at Federal Reserve Banks) with each other overnight.” FRED. The rates are set through a mechanism known as open market operation, a tool used by central banks worldwide to fine-tune liquidity within the system. Undoubtedly, the U.S. and the world went through a colossal human and economic crisis, boosted by a ~$5 trillion fiscal stimuli, the U.S. is back in the game. The FED expects the economy to grow by 6.5 percent next year, an excellent achievement for an advanced country. The unemployment rate will fall to 4.5 percent by the end of this year (median projection) and expected to be 3.5 percent by 2023. The unemployment rate would be close to the natural rate by the end of this year based on the Congressional Budget Office estimates the U.S. natural unemployment rate is about 4.4 percent. According to Jerome Powell, “The median inflation projection of FOMC participants is 2.4 percent this year, will decline to 2 percent next year before moving back up by the end of 2023”. As of March 2021, the U.S. fiscal stimulus as a percent of GDP amounts to 26.64 percent or ~$5 trillion, the highest in absolute terms, among the top 5 in G20 countries. Further, since 21 March 2019, FED has added ~$2.3 trillion of assets.
Graph Data Sources: Board of Governors; CBO; BEA; fred.stlouisfed.org | The middle Road
According to Taylor’s rule, the real federal rate is a function of inflation and GDP gap.
Taylor’s Rule: Real Federal Funds Rate= 2 + 0.5 (Inflation -2)-0.5(GDP gap)
YouTube | The middle Road
Looking at Taylor’s rule the general impression is that the rates should go up earlier than expected. If the GDP rises above the natural level of GDP, the real GDP goes up. Okun’s law shares the relationship between the unemployment rate and rate of growth within an economy. A decrease in unemployment rate esp. below the natural rate would lead to an increase in GDP growth. The middle Road will do a deep dive to understand the view of the FED on interest rates. The interest rates in the US have already been low for an extended period of time resulting in the longest secular bull run in US history before the pandemic. Further, the FED will buy at least $120 billion of Treasury ($80 billion) and asset-backed securities ($40 billion) purchases per month. Since 21 March 2019 FED has added ~$2.3 trillion of assets. Fed rates are a barometer for interest rates within an economy, serve as a reference for loans with low-interest rates boosting credit during recessions. However, an era of prolonged low rates enables structural inefficiencies within an economy through asset bubbles.
Jeeves says we are living in an era of the mother of all asset bubbles.
Taylors Rule & FED Rates — Macroeconomics
The increase in liquidity due to low-interest rates leads to artificial inflation of asset prices, increasing systemic risk within the financial markets. All asset classes might be performing better than their true intrinsic worth in such times. For estimating intrinsic values of equity and debt assets, calculating the net present value of cash flows is used. The free cash flow model is one of the best methods of valuing equities. Refer to the read-on term structure of interest rates to overview debt markets.
The graph and the educative video (Taylors Rule part of the Module 8 Macroeconomics Stabilization policies) are added after the note was published, reedited without altering the essence of the original piece. Taylors Rule & FED Rates — Macroeconomics words have been added.