Fed funds rate will rise in 2016

It’s status quo. She has not changed the rates.

With a growth rate of around 3.5% and better and brighter jobs data, the general expectation in early August was that the Federal Funds rate would be hiked in this policy meeting. However, as China devalued the yuan, global markets went into a major turbulence episode. Further, reduction in the Chinese interest rates caused uncontrolled outflows from all asset classes in EMs and showed markets moving to the dollar, like they always do in troubled times.

A hike in US interest rates, at such a time, could cause further disruptions in an already volatile environment; it is with this view in mind that the Fed has not changed the interest rates in this policy review.

However, this keeps us in a tentative state of mind and markets till December, which is when the next guidance is scheduled.

What I attempt in this blog is to try and see where the rates are headed in a medium term outlook, as we move into 2016.

The Taylor Rule and the Fed Funds Rate

The Taylor’s Rule is a rule that prescribes the nominal interest rate charged by the Fed be dependent on output gap, divergence of actual inflation from the target and on the equilibrium interest rate in the following fashion.

it = πt + 0.5 (πt – πt*) + 0.5 (GDPt –GDPt*) + rt*;

where it is the is the nominal Fed funds rate, πt and πt* are the actual and targeted inflation rates, GDP* is potential output and rt*is the equilibrium real interest rate.

Is the rule really used by the Fed to set interest rates? As Ben Bernanke said recently, Fed fund rates should be set systematically, not automatically. Using the Taylor’s rule to determine Fed funds rate is too simplistic, given that economic conditions keep changing all the time. Thus, the Fed does not actually set its rates by the Taylor’s rule; however, studies do show correlations between the rate as determined by the rule and the actual Fed fund rates.

If the Achilles heel of the rule is its simplicity, that perhaps is also its biggest strength. The rule connects movements in economic fundamentals to interest rates, giving us an analytical tool to create a baseline understanding of how rates will move in the future.

Higher is the inflation as compared to the target inflation (about 2% for the past 4-5 years in the US) and more is the GDP as compared to the potential GDP (that level of GDP at which all labor and capital resources are fully employed), more is the nominal funds rate that the Fed ought to set in order to cool down economic activity. The Fed Funds rate also depends on rt*, the equilibrium real interest rates in the economy. Equilibrium real interest rates are those at which the output and inflation are absolutely at target and monetary policy is said to be neutral. In a recession and low asset prices, the equilibrium real rate required to get the system to a higher growth level would have to be very low. Easier said than computed.

The following table shows the output gap (OECD data) and core inflation (Bureau of Labor Statistics) for the US from 2009 to 2015. Core inflation was chosen rather than CPI due to the high volatility that oil and food prices have shown in the time period. Under the very simple assumption that the Fed fund rate corresponds closely to the Taylor rate computation, we realize that the equilibrium real interest rates in the US for the said period have been extremely low, in fact negative at times, as many analysts have suggested.

Year Core inflation (Fed data) Output gap (OECD data) Fed Funds Rate Equilibrium real rate
2009 1.7 -4.535 0.25 0.97
2010 1.0 -3.786 0.25 1.64
2011 1.7 -3.913 0.25 0.66
2012 2.1 -3.428 0.25 -0.19
2013 1.8 -3.016 0.25 0.06
2014 1.7 -2.476 0.25 -0.06
2015 1.7 -2.363 0.25 -0.12
2016 (forecast) 1.8 -1.631 0.75

0.88

1.38

-0.12

0.00

0.50

Taylor’s Rule to forecast interest rates

It may be fruitful to attempt understanding the movement of Fed Funds rate in the next one year using this analysis.

There are plenty of signs of strengthening in the US. As per OECD forecasts, the output gap will reduce in 2016, indicating better utilization of resources. Unemployment rate is already at around 5.2%, which is lesser than 5.5%, the natural rate of unemployment for the US, at which we assume that labor is almost fully employed. Since January, personal consumption expenditure index has been growing at an average of 2.2%. Real interest rates are bound to rise in the immediate future.

Even if we assume the same low negative real interest rates for 2016, the Taylor rule calculation tells us that the Fed Funds rate will jump up by 50 bps in the immediate future (Graph shown below). More realistically, if we assume the real interest rates to be 0% or 0.5% in 2016, the corresponding funds rate would jump to 0.88% and 1.38% respectively.

image002

Ceteris Paribus, the way the fundamentals are evolving right now, a rate hike over the next one year seems imminent. This is not only because the fundamentals are strengthening; it is also because keeping interest rates unnaturally low beyond the required time-frame can have heavy costs in terms of asset bubble formations. To presume that the Fed will delay internal adjustment to allow a smoother glide path to EMs is just too naive for words.

Even if the hike has been postponed as of now, directionally the markets will have to get poised for a higher Fed funds rate between 1 to 1.5% in the next one year.

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