Friday, October 12, 2012

Taylor rule suggests that the overnight rate should be over 1%

John Taylor, the author of the Taylor Rule, has argued on numerous occasions (even prior to the QE3 announcement) that the Fed's policy has been too accommodative. In fact if one applies a form of Taylor Rule to current conditions, not only is the Fed's balance sheet expansion inappropriate, but the overnight rate should actually be raised in order to reach a balanced monetary policy. In addition, the overnight rate should be rising steadily going forward (see chart below) instead of being held at zero into 2015, as the FOMC has telegraphed.
DB: - Taylor, who introduced the “Taylor rule” for setting short term policy rates in his seminal 1993 paper, has argued that policy rules suggesting negative interest rates – and hence the need for unconventional policy tools such as LSAPs – are calibrated to inappropriate time periods or include suspect estimates of long term equilibrium short rates. A Taylor-type rule, which places equal weight on the output gap and inflation gap, uses 2% as the equilibrium short rate, and uses an Okun’s law coefficient of 2.3 suggests that Fed funds should already be over 1% and should rise steadily during the period in which the current FOMC has made its conditional commitment to policy accommodation.
Source: DB

DB argues however that if Romney were to become president by some chance and remove Bernanke from the Fed, the central bank's policy would not change materially. Even with a new hawkish Fed chairman (like John Taylor for example), the dovish nature of the FOMC lineup going forward would prevail at maintaining the status quo monetary policy at the Fed.



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