A post by Annaly Capital Management.
There has been some chatter recently on the direction of traditional monetary policy (i.e., the Federal Reserve changing the Fed Funds target rate to influence the availability and cost of money and credit to help promote national economic goals), with most of it involving a pushing out of the first date of a Fed tightening. Just yesterday, the US economic research team of JP Morgan edged their expectations for the first rate increase from the second quarter of 2011 to the fourth quarter. “The prime motivation for the change is the behavior of inflation,” they write. Credit Suisse had earlier delayed their call for the first hike from late 2010 into next year, and Deutsche Bank pushed theirs out from third quarter 2010 to fourth quarter 2010 (with a year-end call of 75 basis points). Blaming the European debt crisis, UBS now thinks the first tightening will happen in January 2011 and not September 2010. The monthly Bloomberg survey of street economists shows the consensus has moved its call to the first quarter of 2011; in December 2009 the consensus was for third quarter of 2010.
As we type, the Fed Funds futures market is also changing its thinking. This market is projecting that there will be no hike until after the first quarter of 2011, with a 66% chance of a 25 basis point hike to 0.50% at the April 27, 2011 meeting. Back in March, the market thought that there was a better than 50% chance of a hike at the November 3, 2010 meeting.
These changes in outlook are generally reflective of a baseline view of the overall economy (econometric or qualitative) overlaid by a tea-leaves reading of Fed-speak and Fed politics, with any changes coming about because of market-based events or a new data point or trend change. An interesting piece of research published on Monday by the Federal Reserve Bank of San Francisco ignores all that. Instead, it goes back to the basics of the Taylor Rule, which tries to determine how monetary policy should react in response to changes in economic conditions. In this instance, the author of the piece, Glenn Rudebusch, uses a simple policy guideline that would call for lowering the Fed Funds rate by 1.3 percentage points if inflation falls by 1 percentage point, and by 2 percentage points if the unemployment rate rises by 1 percentage point. His conclusion? The Fed will be on hold until late 2012, which is well more than a year beyond the Street and futures-market consensus.
Below we reproduce the main graph from the San Francisco Fed’s piece. It’s clear the rule-based target rate generally tracks with the Fed’s historical target rate, and only diverges today because the Fed Funds rate can’t be lower than zero. According to the rule, the current Fed Funds rate should be around -5%. Interestingly, the rule-based target calculation utilizes consensus projections for economic activity, inflation and unemployment, but it arrives at a different conclusion than the Street and the futures market. Even as consensus projections show unemployment moderating and low inflation slowly picking up in the years ahead, the rules-based approach suggests the target rate is still negative, meaning the Fed’s target rate would remain at zero well beyond the turn in the economy. On the other hand, the market consensus is factoring in such things as the results of fiscal policy or other exogenous factors, or thinking the Fed will lean into any sustained recovery. Or maybe the Taylor Rule just doesn’t work in a low rate environment. (If we read the graph properly, if nominal rates were 500 basis points higher right now the Fed would be tightening, all other things being equal.) But that’s what makes a market.