Taylor Rule Suggests Target Federal Funds Rate Should Be Higher
Both overnight and long-term rates are being forced lower by a combination of money-printing and buying from foreign central banks.
Or, as I am fond of saying, "When you age bad wine, you get old, bad wine."
The Taylor Rule
If I have not made it clear by now, I am not a big fan of price-fixing in any form, especially from a body such as the Federal Open Market Committee involved in pretending monetary policy has deterministic outcomes. If they could have predicted the consequences of their previous bubble-inflating escapades as well as they have denied their involvement therein, I might have a different opinion, but they cannot and I do not.
If we are to tinker with the price of overnight money between consenting adults and Federal Reserve member banks, we should at least have a rule-based guide, such as the one offered by Stanford professor John Taylor. It involves inputs such as inflation; unemployment; the "Okun Factor," or link between the output and employment gaps in the economy; and other folderol such as NAIRU, or non-accelerating inflation rate of unemployment.
If you walk through the Taylor Rule piece by piece, you will understand its output is determined in large part by inputs with substantial statistical error bands. But it is a computer study, so we must obey.
Presented below are the Taylor Rule estimates for the target federal funds rate since December 2008, the beginning of the ZIRP (zero interest rate policy) era. Please note how the estimates reached their low point in July 2009, when Federal Reserve Chairman Ben Bernanke let it be known there would be no impending rate hikes, and how the estimates were again negative in mid-2010, right before Jackson Hole. Today the estimate is positive and centers on a target federal funds rate of 1.25%. Why are we talking about the possibility of QE3?
But, as they say on late-night television, "Wait! There's more!" I have my own computer-generated model of where the yield curve should be given present conditions and, without boring you with the mechanics, it says the yield curve spread between two- and 10-year Treasuries (think of iShares Barclays 1-3 Year Treasury Bond (SHY) and iShares Lehman 7-10 Year Treasury Bond (IEF)), now about 170 basis points, should be about 310 basis points. As it would be very difficult for the yield curve to steepen by two-year rates driving lower, that should mean 10-year Treasury rates should go higher. They have declined since Operation Twist began in August 2011.
There you have it: The overnight rate should be higher and long-term rates should be higher. They are being forced lower by a combination of money-printing and buying from foreign central banks. Whenever you hear someone puzzle why Treasuries are unloved, think of this: Any rational person should hesitate to buy an asset propped up artificially. Or, at least that is what the computer says.
The information on this website solely reflects the analysis of or opinion about the performance of securities and financial markets by the writers whose articles appear on the site. The views expressed by the writers are not necessarily the views of Minyanville Media, Inc. or members of its management. Nothing contained on the website is intended to constitute a recommendation or advice addressed to an individual investor or category of investors to purchase, sell or hold any security, or to take any action with respect to the prospective movement of the securities markets or to solicit the purchase or sale of any security. Any investment decisions must be made by the reader either individually or in consultation with his or her investment professional. Minyanville writers and staff may trade or hold positions in securities that are discussed in articles appearing on the website. Writers of articles are required to disclose whether they have a position in any stock or fund discussed in an article, but are not permitted to disclose the size or direction of the position. Nothing on this website is intended to solicit business of any kind for a writer's business or fund. Minyanville management and staff as well as contributing writers will not respond to emails or other communications requesting investment advice.
Copyright 2011 Minyanville Media, Inc. All Rights Reserved.
Daily Recap Newsletter