By Richard de Chazal, CFA
President Trump’s address to Congress on Tuesday was viewed as being a bit of a disappointment, particularly by the financial markets who were hoping to finally hear some more detail on his tax reform proposals. Nevertheless, they quickly gathered themselves together and, reverting to type, rapidly focussed their attention back on the Fed and monetary policy. Specifically, they homed in on New York Fed President Dudley’s comments that the possibility of a rate hike is now “a lot more compelling” and that he expects one to take place in the “relatively near future.” While this statement, somewhat ironically, contained significantly less detail than President Trump’s address, to financial markets the message was crystal clear—expect a March rate hike. Futures market probabilities of an increase correspondingly shot up to 80% (latest reading 86%), from 40% just prior to this comment. In this week’s Economics Weekly, we take a look at one aspect of Fed policy and how that might change with a Trump presidency.
President Trump now has the power to make some very significant changes to the makeup of the Federal Reserve. There are two empty seats on the Board of Governors, and the recent resignation of Daniel Tarullo will bring that to three. Additionally, Janet Yellen’s term as Fed Chair expires February 3, 2018, and Vice Chair Stanley Fischer’s ends June 12, 2018. This means that over the next year, the President (with Senate approval) will have the power to appoint 5 of the FOMC’s 7 Board of Governors if he decides to replace both Yellen and Fischer. His choices could, therefore, significantly alter the nature of the Fed’s policy decisions.
One quite dramatic change would be the appointment of a board that is much more in favour of a strict rules-based approach to policy, i.e., the adoption of a Taylor-type Rule. This is not something that the current members of the Fed are in favour of and they have been fighting against it for many years now. However, pressure to go down this path is clearly increasing from many members of Congress and by a number of prominent economists, unsurprisingly perhaps, including John Taylor himself, whose name has been raised as a possible next Fed Chair. Hence, we were not surprised that the recent speeches from both Stanley Fischer and Janet Yellen have been used to highlight some of the failings of pursuing monetary policy in this manner. Both argue that while rules are a useful policy guide and should not be ignored, the models are not yet robust enough to replace the nuanced view of a seasoned economist.
The Taylor Rule, as defined in his 1993 paper, equates to:
Nominal fed funds policy rate = target inflation rate + neutral real fed funds rate + α Inflation Gap + β Output Gap.
Where the neutral real policy rate, or R*, is assumed to be constant at 2% and the coefficient weights of α and β are 0.5. The rate is viewed as neither a floor nor a ceiling, but as an anchor of where the actual rate should be.
Hence, if both the inflation gap (measured as actual inflation – target inflation) and the output gap (actual GDP – potential GDP) are zero or the resources of the economy are being fully utilised and inflation has achieved its 2% target, then the recommended real policy fed funds rate should be the longer-term real neutral rate of 2%, or 4% in nominal terms. Hence, for example, if inflation is 1 percentage point above the inflation target of 2%, then the rule dictates that the funds rate should be increased by 0.5 percentage points; or the same if actual GDP is 1 percentage point above potential.
In theory, this is beautifully simple and makes intuitive sense. In practice, however, it is rife with problems. For example, in chart 1, which plots the effective fed funds rate against the original Taylor rule, it shows the rate having gone negative during the financial crisis, to which the Fed had to respond with QE being limited by the zero lower bound. However, since then, the rule has been suggesting a policy rate that is much, much higher than the roughly 0% policy rate. In fact, the rule is currently telling us that the fed funds rate should be at 2.87% instead of its current 0.66%.
What accounts for this dissonance? The truth is that the model depends on its input, and most of the issues here are quite well known—for example, which inflation index to use (Taylor used the GDP deflator, the Fed prefers the core PCE), how to measure the output gap (the CBO’s measure, or a variety of other measures including the Fed’s own), and whether or not the coefficient weights of 0.5 are appropriate (Bernanke and Yellen argue that 1, is a better measure in order to have a stronger response to changes in the output gap).
It also depends on what is one of the biggest debates at the Fed right now, and that is the current level of R*, or the real long-term neutral level of the fed funds rate. Taylor assumed a constant real 2%, or a 4% nominal figure. However, most economists now believe that this rate is far from constant and much more variable. The FOMC itself has lowered its estimate over the years since the crisis from 4% to 2.85% and now back up to 3% (the final column of dots in the dot plot). Just how low you place your dot is largely dependent on the extent to which you believe that the (global) economy is suffering from some kind of secular stagnation brought on by adverse demographics, a global savings glut, and weak productivity. Is it an extended slowdown or just a cyclical one? The dispersion of the dots suggest some quite different opinions.
The reality is that even very small changes to one’s estimates for any of these factors can have large changes to the policy prescription. Chart 2 plots an adjusted rule that used the core PCE price index and Bernanke’s suggested weights of 1 rather than 0.5. As might be expected, it called for much more radical decreases in the funds rate when the output gap was severely negative. However, now that things have improved, it is calling for a higher rate than the original Taylor rule. Importantly, the data used in chart 2 also includes the pre-revised PCE and GDP data, i.e., the data the policymakers would have been looking at when the decisions were being made.
This is all well and good, and the rules can be fiddled with in other ways to massage them into giving us more realistic prescriptions for rates. However, there are three very important areas that are not captured by this rule and that, at this point in time, are particularly imperative for policymakers to try to account for. These include:
- The expected future impact of fiscal policy at a time when spending is expected to ramp up considerably;
- The impact from global financial conditions: due to global financial market liberalisation and globalisation, the feedback channel for changes in financial conditions back into the real economy has widened significantly, as was demonstrated during the latest financial crisis;
- The size of the Fed’s balance sheet and the likelihood that it will increasingly be deployed as a tool to effect changes in interest rates further along the yield curve. In fact, Bernanke has argued that due to the amount of reserves currently held at the Fed, the fed funds rate has become much less of an effective tool in directing policy changes and the Fed’s balance sheet should be kept large in order to better direct the flow of credit and achieve its mandated goals.
These factors can have a very significant influence on the direction of the economy and financial markets, but they are not reflected in the alluringly simplistic policy model described by the Taylor rule or any of the adjusted Taylor rules.
President Trump now has the power to make some very significant changes to the makeup of the Federal Reserve—at a minimum three members of the Board of Governors with a further two if he decides to replace Yellen and Fischer. The choices he makes could radically alter the future path of monetary policy, particularly if he chooses those economists (of which there are many prominent ones who are viewed favourably by the Trump administration) who favour following a hard-line rulesbased prescription approach to the level of the nominal fed funds rate. There are numerous well-known problems with these policy prescriptions, as well as other newer issues that have emerged since the financial crisis that are not reflected in the Taylor tule-type models and could, therefore, quite easily misdiagnose the situation and prescribe the wrong kind of medicine, resulting in further harm. Policy rules are a useful guide and should not be ignored, but they are no replacement for a more-nuanced approached (at least for now).
Richard de Chazal is William Blair Intl. Ltd.’s U.S. macroeconomist from London. He is a Chartered Financial Analyst and has previously worked at UBS Warburg and PaineWebber Intl. Ltd.
Richard de Chazal attests that 1) all of the views expressed in this research report accurately reflect his personal views about any and all of the securities and companies covered by this report, and 2) no part of his compensation was, is, or will be related, directly or indirectly, to the specific recommendations or views expressed by him in this report. We seek to update our research as appropriate. Other than certain periodical industry reports, the majority of reports are published at irregular intervals as deemed appropriate by the research analyst.