Taylor Rule Says The Fed Should Be Tightening Now

Once upon a time, the Federal Reserve decided to adopt the Taylor rule, named after Stanford economist John Taylor, as its key determinant in setting the Fed Funds rate. Then, after it realized that the original formulation of the Taylor rule was too constricting and not as permissive to pro-inflationary policy as the Fed's financial sector superiors demanded, it decided to adjust the Taylor rule formulation to its own parameters so that it was always in sync with whatever policy, monetary or as of QEterenity, pseudo-fiscal, it decided to pursue. In the meantime, John Taylor has become one of the more vocal critics of Ben Bernanke's printing ways if for no other reason then because the original Taylor rule says that instead of ZIRP at least until 2015, the Fed should be tightening right now.

Guggneheim's Scott Minerd comments:

Following the latest FOMC meeting, the committee announced a new asset purchase program and an extension of their low rate pledge through mid 2015 in an effort to stimulate economic growth and improve the labor market.  In addition, the FOMC also released its latest outlook on inflation and unemployment.  Based on the new estimates for inflation and unemployment, the optimal Federal Funds Target rate suggested by the Taylor rule would suggest the Fed funds rate should rise to over 2% by mid-2015, in contrast to the Fed’s pledge to keep rates near zero through that time. In light of this analysis, it appears likely that the FOMC will fall behind the curve in raising rates, especially given its new outlook on economic growth and its pledge to keep rates on hold through mid 2015.


What this means is that by the time 2015 rolls by, all else equal, the Fed will be far behind on the tightening curve and when it finally does admit tightening is overdue, it will have to scramble to not only hike short-term rates, but promptly proceed to commence offloading its balance sheet which as we calculated will be $5 trillion by then, or nearly 100% higher than it is now, and with a DV01 of $4 billion. Oops.

What this will mean for risk, i.e., stock prices, is self-explanatory. Luckily for Bernanke, by then the collapse in the stock market which will finally shift to a phase of liquidity extraction, will be some other Fed Chairman's problem.