formula for forcasting central bank rates

To raise or not to raise; that is the question.

With the US and global economies on the brink of a potential recovery when and how much should the FED raise interest rates? Let’s start off by looking at a formula often used by traders to predict the target rate for a central banks short term interest rates. Proposed by John Taylor in 1993 the (Taylor Rule) is widely accepted by economists today as a gauge for appropriate interest rate levels in conjunction with current economic conditions. We are able to predict how much a or if a central bank should change short term rates as real inflation and/or real GDP diverge from the target inflationary rates and potential GDP. If you take the a central banks target interest rate comparably with GDP growth expectations and inflationary figures i=N + 0.5(Y-Y*) +0.5(P-P*) will give you the short term rate target.

The formula breaks down into a simplistic form; i is the short term nominal interest rate, N is the neutral rate subtracting the short term interest rate with target GDP and inflation at the mean. Y is the GDP forecasted growth rate, Y* is the observed GDP growth rate, P is the forecasted inflationary rate and P* is the targeted growth rate.

Using this formula to forecast future expectations suggests GDP growth rate and/or forecasted inflation rate are above trend target levels, short term rates should be increased by half the difference between the forecasted inflation rate and target trend levels. If forecasted GDP growth rate and forecasted inflationary rates are below the trend and target levels short term interest rates should be reduced accordingly.

You can also factor in i=N+a(P-P*) +b(u-U*) using I as the target short term nominal interest rate, N as the neutral rate, a as the inflation gap coefficient, P is actual inflation, P* is the inflationary target , b as unemployment gap coefficient, U is the actual unemployment rate and U* is the Non-Accelerating Inflation Rate of Unemployment (NAIRU)

Using Taylor’s model in conjunction with current unemployment rates and inflationary pressures suggests the Fed Funds Future rate needs to be near -2.25% during the first quarter of 2009. looking out to the second half of 2009 factoring in forecasts for unemployment and inflation rates through the second half of 2010 would suggest the policy rate would near -5.5% during the 4thQ of 09 and would stay negative throughout 2010 and into 2011. Because the FED can not create a negative Fed Funds Future rate by pushing rates below 0% they have adopted quantitative easing measure, (QE) in order to promote growth and stability to markets. Going back to the second half of 2008 the US Federal Reserve bank has expanded its balance sheet in order to lower cost and increase liquidity. The FED has implemented 300 billion worth of quantitative easing measure’s since April that have included buying long term treasuries over the next 6 month in addition to 1.5 trillion dollar purchase program of mortgage debt plus 1.25 trillion in mortgage backed securities. Through this quantitative easing program the FED has more then doubled the size of there balance sheet to over 2 Trillion dollars. If we add Taylor’s rule to current market conditions and forecast unemployment and inflationary pressures this would suggest that further quantitative easing measures will need to be implement by the FED before the year is out. This will undoubtedly lead to (hyper inflation) see my previous article from April 2 2009 http://www.jdfn.com/profiles/blogs/hyperinflation-is-staring-us with unchecked inflationary pressures the FED will need to reduce the size of there balance sheet and/or tighten monetary police to mop up areas of liquidity. The markets may start factoring in a FED rate hike by as early as December 2009 the yields on short term bonds (2 year) spike following Non-Farm payroll and the unemployment rate on Jun 5 pushing up nearly 50BPS making that move higher one of the largest since 2007.

When we look at the dollar index we see a grim picture ahead for the greenback, this is an Index that is weighted nearly 50% against the Euro. The yield by the dollar index suggests monetary policy tightening needs to take place in order to prevent yields from inverting. With signs of stabilization in not only the US but global economies and additional capitol liquidity supply side economics dictate further weakness for the dollar if the FED does not act.