June 7, 2023
Good morning,
Let’s briefly return to the classroom this morning and talk about The Taylor Rule. Stanford economist John Taylor originally proposed the rule as a rough guideline for monetary policy. It is an equation linking the Federal Reserve’s benchmark interest rate to levels of inflation and economic growth. A formula that ties the Fed’s key interest rate policy instrument, the federal funds rate, to two factors: the difference between the actual and targeted inflation rates and that between the desired and apparent growth in the real Gross Domestic Product (GDP).
There’s a solid reason why the markets have re-calibrated their view on the Fed’s trajectory in recent weeks: at its current level, its policy rate simply doesn’t have enough bite to get inflation down to its target (Bloomberg). The famous Taylor Rule shows that the restrictive rate for the U.S. economy is between 5% and 6.55%, meaning the Fed’s mid-rate at 5.125% is hardly getting the job done. Despite all the tightening we have seen in the current cycle, the core PCE (Personal Consumption Expenditures Index) has come off just 70 basis points from its peak. That means that core inflation (currently 4.7%) is nowhere near the Fed’s estimate for this year (3.6%), let alone its 2% target.
Interest rate traders are currently assigning a higher probability of a July 25bps rate hike than one in June. Following Monday’s Morning Note, this would be another hint that our rally may have legs into July.
Be well,
Mike