From her Jackson Hole speech US Fed Chair Janet Yellen used the Taylor Rule to suggest that the Fed Funds rate today should already be around 1.33% – currently at 0.50%. She also used the Taylor rule to explain how US interest rates should have been negative after the Global Financial Crisis. This same rule suggests that the rate should already have been 1.25% in June – see Chart below.
Source: National Australia Bank: Australian Markets Weekly – 5th September
What is the The Taylor Rule?
This is a specific policy rule for fixing interest rates proposed by the Stanford University economist John Taylor. Taylor argued that when:
Real Gross Domestic Product (GDP) = Potential Gross Domestic Product and
Inflation = its target rate of 2%, then the Federal Funds Rate (FFR) should be 4% (that is a 2% real interest rate).
If the real GDP rises 1% above potential GDP, then the FFR should be raised by 0.5%.
If inflation rises 1% above its target rate of 2%, then the FFR should be raised by 0.5%.
This rule has been suggested as one that could be adopted by other central banks – ECB, Bank of England, etc for setting official cash rates. However, the rule does embody an arbitrary 2% inflation target rather than, say 3% or 4%, and it may need to be amended to embody alternative inflation targets at different times or by different central banks. The advantages of having such as explicit interest rate rule is that its very transparency can create better conditions for business decisions and can help shape business people’s and consumers’ expectations. Central banks prefer to maintain an air of intelligent discretion over the conduct of their policies than to follow rules, but to some extent they do unwittingly follow a Taylor rule. This makes the rule a useful benchmark against which actual policies can be judged.
A HT to Yr 13 student Albere Schroder for alerting me to this interview with the four most recent US Federal Reserve chiefs.
- Janet Yellen, the current Federal Reserve chairwoman was joined by:
- Ben Bernanke (2006-2014)
- Alan Greenspan (1987-2006)
- Paul Volcker (1979-1987)
Although the Fed Reserve chiefs served during widely divergent eras and are known to have different political views, the most notable take-away of the evening was the extent of their deep agreement.
There was a consensus that the Fed’s post-crisis rescue efforts have been successful and the economy is currently on a steady growth path, rather than rising thanks to a bubble that will soon burst. The remarks were a sharp rebuttal to the conventional wisdom of the contemporary Republican party and many grassroots conservatives that excessive stimulus from the Fed is either on the verge of sparking a drastic uptick in inflation, or already fostering a stock market or asset bubble.
“I’m not saying that the government should always be spending,” Bernanke said. “But at certain times, particularly in a recession, when the central bank is out of ammunition or ammunition is relatively low, then fiscal policy does have a role to play, yes.” Ben Bernanke
Greenspan had other ideas in that he disagreed with the idea that government spending should be increased during a downturn as this impacts on the country’s longer-term debt problem. Worth a look.
The TED spread is the difference in rates between the interest rate that the US Government is charging for cash (three-month Treasury-Bills – the “T”) and three-month Eurodollars (the “ED”) contract as represented by the London Interbank Offered Rate (LIBOR).
The TED measures the rate of return the banks are requiring over the risk-free Treasury Bill rate to lend to other banks. If the economy is healthy the TED spread tends to be at low levels as there is a lot more trust in the market and the risk of default or bankruptcy is low. On the contrary, when the economy goes through a downturn levels tend to be higher as banks become more prudent in their lending and this reflects some sort of risk or liquidity premium. As the spread increases, the risk of default is considered to be growing. Ultimately TED illustrates the level of anxiety banks have that other banks are going to default – some liken it to a kind of measure of the financial sector’s blood pressure.
In 2006 and for half of 2007 the TED was consistently under 1%, which is historically low. However in August 2007 with the advent of the sub-prime crisis there were indications that all was not okay on financial markets. This was soon followed by the freezing of funds by investment bank BNP Paribas and consequently the TED spiked at 1% for the first time in a decade. From this point on the credit crunch was accelerating and markets were becoming extremely volatile. With the collapse of Lehman Bros the credit market became very explosive and the TED went through the 3% level, which exceeded levels last seen in the crash of 1987. Subsequently, a number of US and European banks collapsed and interbank lending just about came to halt. Liquidity was reduced dramatically and the TED peaked at 4.65%, a point never witnessed previously. To counter this problem Governments around the world promised trillions of dollars in bailouts and bank guarantees that, in the end, restored some confidence in credit markets – the Ted fell from its peak to about 2.25%.
Recently the TED Spread moved from 0.21% at the end of 2015 to 0.43% on 11th January 2016 . That is its highest level since 2012, when markets were pressured by fears of a sovereign-debt crisis in Europe.
Treasury Bill Yields – down
In order to protect themselves from runs during market turbulence, investment companies are shifting funds to government stock which is more secure. That adds to demand for T-bills which increases their price and reduces their yield
Libor – up
Rising demand for T-Bills has reduced downward pressure on the Libor. Furthermore the increase in the US Fed rate last month resulted in a rise in the Libor and a number of other benchmarks.
However the TED spread’s surge is a mechanical result of its two components moving in different directions for reasons mostly unrelated to the creditworthiness of banks. Treasury-bill yields are down, Libor is up, so the TED spread is up, too. ‘Wall Street Journal’.
Data out of the US seemed to warrant the Federal Reserve’s decision to raise its benchmark interest rate by a quarter of a percentage point to between 0.25 percent and 0.50 percent on December 16th 2015. Below is the data:
- Unemployment – was at 5% although the US lost 8.7m jobs during the recession it has gained 13m since then.
- Wages – have been increasing to 4% in the Q3 2015 suggest that there is little surplus labour available.
- Oil prices – may have bottomed out so this suggests inflation may pick up in 2016. As there is a pipeline effect with the impact of higher interest rates it may be prudent to increase rates sooner.
What are the concerns?
- Wages increases maybe temporary especially if young workers are enticed back into the labour market.
- Inflation is 0.2% which is well below the 2% target. Even when you take out energy and food prices core inflation is only 1.3%
- Interest rates are still very low and there is little scope for cutting them if the increase has a slowing effect on the economy
- With most Americans on fixed mortgages the interest rate increase has a limited impact on the cost of borrowing.
- A higher US dollar will make exports less competitive and Americans manufacturers will struggle evenmore trying to sell in overseas markets.
Stanley Fischer, the Fed’s vice-chair, recently estimated that a 10% rise in the dollar reduces core inflation by half a percentage point within six months. The US Fed chair Janet Yellen is unlikely to persist with rapid rate rises if they push inflation too far below target in the short term.
Source: The Economist – 18th December 2015
John Cassidy wrote a piece in The New Yorker which focused on the US Fed targeting the threat of bubbles rather than inflation when implementing policy instruments. In the mid 1990’s and early 2000’s the Fed set interest rates based on the supposed threat of inflation. However price rises never materialised so the low interest rates fueled borrowing especially for purchasing property.
In the past, expansionary monetary policy (low interest rates) would have acted as a catalyst to the real danger of a wage price spiral in which rising wages and prices become self-reinforcing, pushing inflation up. This was very apparent in the winter of 1974 in the US when inflation reached 12% and 15% by 1980. But today with the annual rate of inflation in the US at less than 2% for the past three years the threat of another wage price spiral is fairly dormant. It was forecast that that wage and price inflation would start to rise but average hourly earning rose by just 0.1% in January. Over the course of the past year, it has risen by 2%, which is a very modest rate of increase.
Economists have never been able to pin down the jobless rate at which inflation takes off—the so-called NAIRU, or Non-Accelerating Inflation Rate of Unemployment. Theoretically, the concept makes sense. Empirically, it’s extremely elusive, because it depends on many other things, such as the rate of productivity growth, tax rates, the labor-force participation rate, and the level of unionisation.
However higher wages will eventually surface with a tight labour market but the real dilemma for the Fed is the tradeoff between cheap money and financial instability. Keep interest rates too low for too long and you ignite another asset bubble or raise interest rates to alleviate the bubble risk but dampen growth in the economy?
The US Fed currently have an interesting problem which other central bank would be happy to have. They have a dual mandate of Price Stability – 2% inflation and Full Employment – 5% unemployment. The current unemployment rate is 5.8%, the lowest level since 2008, and if it drops below 5% there could be labour shortages which will help to put pressure on wages and ultimately inflation. However the current inflation rate is only 1.3% and it is heading below 1% next year. There are two main reasons for this:
* The significant drop oil prices and
* A stronger US$ making imports cheaper
The concern for the US Fed is that inflation over the next couple of years stays well below the 2% threshold and interest rates remain close to 0%. As pointed out by The Economist the problem will be when the next recession rears its ugly head and Fed has no room to cut rates further as they cannot fall below 0%, since savers would simply convert their deposits into cash.
An option might be to let unemployment fall below 5% which make the labour supply more scarce bidding up wages and prices – with inflation reaching the target of 2%. Furthermore higher wages should entice workers back into the labour force. The risk is that with close to 0% interest rates inflation could rebound suddenly forcing the Fed to raise interest rates. How the Fed cope with the dual mandate next year will be interesting although the safe option could be to increase rates in the June this year. Below is a clip from Paul Solmon of PBS which explains the concern that the Fed have. It also stars Merle Hazard with a song about the dual mandate.
Following on from Merle Hazard’s Dual Mandate song, here is a report from Paul Solman of PBS looking at the role of the Federal Reserve with the end of its QE money creation programmes. The US economy is still in recovery mode and the role of the Federal Reserve is being debated. While most central banks have one mandate – price stability – the US Fed has two:
1. Maintaining stable prices
2. Full employment
Paul Krugman doesn’t think the Fed is achieving either of their mandates and would have liked to have seen them continue their bond buying last longer since employment rates and wages are still depressed.