Fed Follows the Taylor Rule Not the Market

Summary

• The Fed expects the end-2024 Fed Funds rate at 2.1%, rising to 2.5% over the longer run. By contrast, markets are pricing 1.8% and 1.7% respectively. 
• The Fed’s forecast appears more likely as it aligns with the Taylor rule and previous normalizations.

Market Implications

• The market could be underpricing 2024/2025 hikes.

The Market is Wrong on the Fed Terminal Rate

The most recent Fed forecast for its policy rate, the dot plot, shows a higher terminal Fed Funds rate (FFR) than the market is currently pricing. I believe the Fed’s forecast is the more likely outcome. A key reason is that the most recent Summary of Economic Projections (SEP) from December is consistent with the Taylor rule that has described past US monetary policy well. 

The Fed’s Dot Plot Aligns With the Taylor Rule

The highest policy rate in each tightening cycle, the terminal FFR, has been declining since the 1980s.  A big reason for this is that the Taylor Rule has also been declining.

The Taylor rule is a rule of thumb that describes monetary policy as reflecting both the deviation of inflation and unemployment from their long-term trends. I use this formula:

R_{Taylor rule}  = R* + Core PCE YoY + 0.5 * (U*-U) + 0.5 * (Core PCE -2%)

Where R* is the natural rate of unemployment, the rate of interest that balances demand and supply in the economy.  I use the FOMC SEP value from 2012 and, before that, the Williams Laubach estimate. U* is the natural rate of unemployment. I use the CBO estimates.

The decline in the Taylor Rule was due a combination of lower inflation, lower R*, larger absolute deviations of unemployment from U*, and smaller deviations of inflation from the 2% target. Since the pandemic, the Taylor rule FFR has surged, but I expect it will retreat near to pre-pandemic trends, in line with my benign view of long-term inflation.

When we compare the terminal FFR to the Taylor rule we find deviation has been stable with the policy rate approaching the Taylor rule value at the end of each tightening cycle (Chart 1).

The December 2021 SEP FFR trajectory is consistent with a gradual convergence to the Taylor rule (inflation only) FFR (Table 1). The December SEP reflects that, even though the Fed officially retired the inflation qualifier ‘temporary’ from its vocabulary, it still sees the current inflation surge as mainly pandemic driven.

The Fed’s Plans Align With Previous Normalizations

When we compare the December 2021 SEP FFR trajectory with previous tightening cycles, including the 1979-81 Volcker tightening, the SEP seems very ambitious. The reduction in the gap between actual FFR and Taylor rule FFR envisaged in the SEP is even greater than that achieved during the Volcker tightening or comparable when adjusted for the longer time period this time. 

However, this time, most of the adjustment is to come from a decline in the Taylor rule FFR because, as explained above, the Fed expects the end of the pandemic to lower inflation. By contrast, during the Volcker tightening, inflation proved stubborn, and the Taylor rule FFR rose during the tightening cycle.  When measured in bp per month, the December SEP pace of tightening is comparable to that of 2015-18 and the slowest since 1979.

Given this very moderate pace, I struggle to imagine the Fed stopping in 2024 – as markets price.

Market Consequences

Whether the Fed’s benign tightening plan pans out depends on whether inflation is ‘transitory’ (with apologies to Powell). If inflation turns out transitory, the Fed forecast will be vindicated and the terminal FFR will end up near the SEP 2.5%. This scenario suggests markets are underpricing hikes for 2024 and 2025, which could imply US 2s5s steepening.

If inflation turns out not transitory, the Fed will have to hit the brakes much harder than it currently plans. This would imply more hikes for 2022 and 2023H1 but big cuts in 2023H2 and 2024 as the US enters a recession and FFR returns to zero. This would imply 2s5s flatteners and weaker stock markets.

Dominique Dwor-Frecaut is a macro strategist based in Southern California. She has worked on EM and DMs at hedge funds, on the sell side, the NY Fed , the IMF and the World Bank. She publishes the blog Macro Sis that discusses the drivers of macro returns.

(The commentary contained in the presentation does not constitute an offer or a solicitation, or a recommendation to implement or liquidate an investment or to carry out any other transaction. It should not be used as a basis for any investment decision or other decision. Any investment decision should be based on appropriate professional advice specific to your needs)