The Taylor Rule, part 2

Part 1

What should interest rates be now?

stir = π+ r* + 0.5(π – 2%) + 0.5(y – y*)

stir = 1.3% + 2% + 0.5(1.3% – 2%) + 0.5(2.21% – 2.2%)

stir = 2.96%

Shockingly, this worked pretty well.  Throwing out the high and low, the Fed’s range of projections for Fed Funds (stir) over the long term is 2.5% – 3% … that’s adequately close to 2.96%!

Now we’ll generate the 3.6% number that I’ve seen floating around Bloomberg for the Taylor Rule.  It’s sometimes quoted as 3.75%, probably because the Fed tends to round to 25 basis points.  There are two differences: 1) inflation is a different metric, and 2) they calculate the output gap differently.

The inflation metric is GDP Implicit Price Deflator (1.6% vs 1.3% PCE ex food and energy), increasing the first term and decreasing the parenthesis with the α1 coefficient.  The output gap (parenthesis with α2 coefficient) is calculated as follows: (Real GDP – Real Potential GDP) / Real Potential GDP.

stir (fomc) = 1.3% + 2% + .5(1.3% – 2%) + .5(2.21% – 2.2%) = 2.96%

stir (Taylor) = 1.6% + 2% + .5(1.6% – 2%) + .5((2.21% – 1.55%)/1.55%) = 3.61%

I guess what I’m trying to show is that it doesn’t much matter if Taylor becomes the Fed Chair, despite the hand wringing or cheerleading from each side.  The Rule isn’t a rule so much as another framework for doing the same thing the Fed is doing now anyway.

Taylor Rule

Here’s what happens if we change some of the assumptions.  Why is long term inflation 2%?  Why is r* 2%?  Lower inflation to 1.5% like we’ve seen recently from PCE, and all of a sudden we’re 40 basis points away from the Taylor Rule … that’s not so much.

Like I wrote yesterday: the rule will get you any number for Fed Funds that you want … it just depends on the assumptions and projections you make.  Just like the Fed does now.

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