Monday, September 17, 2007

175 Basis Points

At the Open Market Committee meeting tomorrow (today if not yesterday or a month ago, by the time anyone is likely to read this), I recommend that the Fed cut its federal funds rate target to 3.5%. This recommendation is based on a direct application of the rule presented in John Taylor’s 1993 paper:

   r = p + .5y + .5(p – 2) + 2

where p is the inflation rate
and y is the deviation of output from potential

Today, the unemployment rate (if you divide the number of unemployed by the number in the labor force instead of using the one-decimal-place figure reported by the BLS) is within 0.01% of the Phili Fed SPF median NAIRU estimate of 4.65%, so y is zero.

The best price index we have is the market-based core personal consumption deflator, which gives an inflation rate of 1.7% (the very last number in this report) over the most recent 12-month period.

Plug in 1.7 for p and zero for y.

   r  =  1.7 + .5(0) + .5(1.7-2) + 2  =  3.55

which rounds down to 3.5

How on earth is Allan Meltzer (hat tip: Greg Mankiw) able to reach the conclusion that the target should remain at 5.25%?

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Anonymous Anonymous said...

You must be joking... can you imagine the carnage that would ensue if the Fed (which is notoriously behind the curve) had the insight (foresight) to drop rates by 175 bp?

Where would that leave the equity markets and the dollar? Not to mention the carry trades and oil?

Tue Sep 18, 04:29:00 AM EDT  
Blogger knzn said...

In this case, though, it's not even a matter of foresight. Taylor's rule is backward-looking, and not very subtle at that. The prescribed drop mostly makes up for the fact that they've been too tight thus far. The implication is that, if they took into account an expectation that conditions will deteriorate, or the recognition that fed funds may not be the most relevant interest rate and that e.g. LIBOR is trading at a wider spread than usual to fed funds, then they should drop by more than 175 basis points.

Granted, if there were a greater than zero probability that the Fed would take my advice, I probably wouldn't advise such a large cut at one time, mostly out of concern for possible instability in foreign exchange markets.

Tue Sep 18, 08:52:00 AM EDT  
Blogger Karl Smith said...

Taylor uses the inflation rate over the last four quarters for p. Using the 12 month trimmed mean PCE deflator of 2.2, we get 4.3 rounded down to 4.25 for a 100 bps cut.

Though, that is certainly not going to happen, I personally don't consider it unreasonable at this point.

Tue Sep 18, 12:45:00 PM EDT  
Anonymous Hafiz said...

you are vindicated! 175 basis points in over 4 months later!

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