Predicting the FED Funds Rate
In today’s article I am going to discuss a simple and easy way to estimate a fair value for the all important FED FUNDS rate and to gauge the likely path of upcoming changes to that rate. The FED FUNDS rate drives investor and trader behavior, market sentiment and valuations. It’s also a key determinant to measure the level and shape of the so-called risk free yield curve.
The FED’s monthly interest rate decisions are widely followed, and for good reason, by both active traders and longer term investors. Accurately predicting changes in the FED FUNDS rate can give you a real advantage in the markets and hopefully lead to excess returns.
The US Federal Reserve, the nation’s arbiter of the Fed Funds rate, has a dual mandate. Indeed the The Federal Reserve Act gives the FOMC a dual directive – to pursue maximum sustainable employment and price stability. These objectives are specifically mentioned in SECTION 2A – Monetary Policy Objectives of The Federal Reserve Act.
The Federal Open Market Committee (herein refereed to as FOMC) has changed the Fed Funds rate eight separate times since September 17, 2007 including a dramatic inter meeting rate cut on January 22, 2008. The last cut, a 25 bp reduction of the rate on April 30th, brought the cumulative amount of easing from the FED to whopping 325 bp so far during this cycle.
After such a spectacular change of interest rates, it’s reasonable for investors and active traders to question whether the next FOMC move will be a further reduction in rates or as the bond markets seem to imply, a hike in rates.
By no means is this an easy question to answer since no one has yet to define what exactly constitutes maximum sustainable employment and price stability. FOMC policy decisions are more than a matter of academic interest.
A recent Special Study by Ford Equity Research, dated March 24, 2008, concludes “It is evident that Federal Reserve rate cuts are very positive for the stock market, frequently leading to strong gains in the period following the cuts.”
So it seems traders may be able to earn excess returns by simply following the old adage “Don’t fight the Fed.”
If Federal Reserve rate decisions are so vital to the probable outcome of stock market performance, at least over the medium term, how then do we reasonably estimate the fair value of Fed Funds and more importantly, whether the next rate move will likely be down or up?
Luckily, the famed Stanford Economist John B. Taylor created an easily understood device aptly called the Taylor Rule, to guide both policy makers and investors on the expected course of monetary policy. Recently, Mr Taylor made a speech titled The Explanatory Power of Monetary Policy Rules, in which he demonstrates that his monetary policy rule is able to explain and predict FOMC policy changes (my words).
You can read the full speech at www.nber.org/papers/w13685. Taylor’s rule can help all investors, even the novices, to sensibly navigate the complex world of US monetary policy. After all, interest rates are a key driver of both real economic activity and financial market performance.
So let’s look at the Taylor Rule and see if we can make a determination if the current Fed Funds (2.00%) rate is too high, too low or just about right. Here is the simplified formula:
r = 1.5p + .5y +1.0
r = the policy or Fed Funds rate, p equals the inflation rate and y is the real GDP gap.
Before plugging in the numbers, please remember that the rule will only give us an estimate of an appropriate Fed Funds rate given what we already know about the economy.
The FOMC and other market participants are more rightly interested in forecasted GDP and inflation one to two years in the future. That’s no easy task given the dynamic nature of the US economy. Nonetheless, Taylor’s rule is still very useful and more experienced investors can use their own forecasts when performing this calculation or simply stick to the most recent published GDP and inflation numbers. So let’s see how Taylor’s rule looks right now.
For inflation, I am using the Fed’s preferred price measure called the Personal Consumption Expenditures (PCE) published by the Bureau of Economic Analysis. The real GDP gap is simply the difference between current and trend GDP. I am using the most recent 10-year average of trend real GDP of 3.1% in my calculations.
The most recent inputs are a PCE of 2.3% annualized and actual real GDP of .6% annualized.
r= 1.5(2.3) +.5(.6%-3.1%) +1.0% = 3.20%
Right now the actual Fed Funds rate is 2.00% and our simplified Taylor Rule indicates that a more appropriate rate may be closer to 3.20%. This doesn’t mean the FOMC has set the rate too low. More likely, it tells us that the FOMC is worried about the prospects for future growth and for the moment, they are willing to set rates somewhat lower than may be warranted. Likewise the FOMC may believe that inflation rates are set to drop over the course of the next year.
One thing is for certain: unless the US enters into a deep recession and or deflationary concerns arise again, the scope for further rate reductions by the FOMC is limited. Of course, further deterioration in the credit markets can alter the situation quickly and dramatically.
A big advantage of calculating the Taylor Rule using your own assumptions is that you can easily measure your results against other market participants. The Chicago Board of Trade (CBOT) lists Fed Fund futures contracts with serial monthly expirations going all the way out to two years.
One hundred less the price of the futures contract represents the market’s expectation of the actual Fed Funds Rate on the expiration date. For example, the April 9, 2009 expiry futures contract was trading at a price of 97.485 on May 6th 2008. That means the market expects the actual Fed Funds rate to rise by 50 bp between now and April 2009. The implied rate is 100 less 97.485 or 2.515%, versus the current rate of 2.00%.
In effect, the market is betting that growth accelerates closer to trend and or prices continue to rise. That is more consistent with our 3.20% Taylor Rule rate that we calculated above.
Prudent investors and traders check their own assumptions against those embedded in the market.
The Taylor Rule gives us a quick and easy way to assess the development of interest rates as set by the FOMC. The Rule is not a scientific theory that returns an absolute value. Rather it is designed to gauge the current level of Fed Funds against reasonable expectations of output and prices.
Think of it as a road map. Long term investment success rarely comes easily. Investors need discipline and skill. It’s easy to get lost along the way.
Edward Talisse is a CFA Charter Holder and Certified Public Accountant. He has more than 20 year’s investment and trading experience gained at Morgan Stanley and more recently at UBS. Edward has lived and worked in New York, London, Paris and Tokyo. He currently lives in Tokyo where he is working on writing a book about building long term wealth. He can be reached via email at: etali14@gmail.com.