Why The Federal Reserve Should Heed The Taylor Rule

dollar ben bernankeDavid Zeiler: Ever heard of the Taylor Rule?

Not many people have, but the folks at the U.S. Federal Reserve are very familiar with it – and they’d probably prefer that this highly respected guideline for the federal funds rate languish in obscurity.

Basically the Taylor Rule is a mathematical equation based on inflation, output, and other economic measures. It was created in 1993 by John B. Taylor, a renowned economics professor at Stanford University.

Ordinarily, the actual Fed funds rate should track within the range of where the Taylor Rule says it should be.

Title: Taylor Rule - Description: C:UsersdzeilerDesktopTaylor Rule.png

And for most of the past 30 years, that’s pretty much what’s happened.

But since 2009, the Fed funds rate has diverged from the Taylor Rule – a divergence that’s getting bigger all the time.

It’s yet another signal that the Fed’s easy money policies – namely keeping interest rates near zero while pouring on quantitative easing (bond-buying) that makes effective interest rates negative – are becoming increasingly dangerous the longer they go on.

If the Federal Reserve were following the Taylor Rule, it would not only need to end all QE immediately, but it would actually have to raise interest rates.

And given the outcome of today’s (Wednesday’s) FOMC meeting, it doesn’t look like the Federal Reserve is going to change course anytime soon.

“The Committee decided to await more evidence that [economic] progress will be sustained before adjusting the pace of its purchases,” the FOMC statement read.

Translation: “We think the economy still needs our help, so we’re going to keep the money-printing presses running at full speed.”

That means the lines on the chart above are going to continue to head in opposite directions.

Pages: 1 2

Leave a Reply

Your email address will not be published. Required fields are marked *