Back in the late 1990’s a debate broke out about targeting the Fed Funds rate as a policy metric. (Oddly, some of the biggest critics..cough Jim Grant..cough are bigger critics now) The oft stated rub was “If you were a monopolist would you peg the price or the quantity of your good? The Taylor Rule is the bastard child of this debate. My problem with Taylor was his inputs, GDP based, were heavily lagged and widely revised. As a Eurodollar guy, I took a market determined money rate as a compass. After several months of tinkering I came up with a rule of thumb: In equilibrium- that is Neutral Fed – the Fed Funds rate “should” be about 60bp under the 12 month LIBOR rate. (This rule solidified itself in our work when it predicted a 1% FF rate well before Sep 11 2001 and indicated the Fed was “too tight” at 1.75)
Taking a small sample of recent January fixes shows the policy tilt into the financial crisis:
Year 12 mo FF Rate “Neutral” Tilt
2002 2.4 1.64 1.8 easy
2003 1.45 1.25 .8 tight
2004 1.47 1. 0 .8 less tight
2005 3.11 2.25 2.5 EASY
2006 4.85 4.2 4.2 neutral
2007 5.34 5.25 4.6 TIGHT-BOOM
The Fed had raised the rate from 1% to 2.25% and was “More accommodating” in 2005 than 2004. Conversely, the 2007 rate hike was overkill, and a key force in the collapse. Once we entered the tail and Quantitative Policy was – once again (Odd sidebar #2, Volcker is praised for QT but Bernanke is vilified for QE) employed, (and LIBOR became a fantasy rate) we wondered how the Rule – more like a guideline – would hold up. Surprisingly, still quite well. If we ask, Where would the funds rate be if the market could set it? The answer today is roughly 10bp with a 12 month set at .697 . Thus the LSAP push is the zero bound policy tool. The question is, given recent movements and explanations: What “Tilt” would policy have if LSAP activity was tapered/halted?
Our model would say today that the Fed would be Neutral. Here’s what to watch for- If 12 month rate sets rise in the days to come, then the Fed finds itself EASIER than present even as/if/when LSAP becomes SSAP or nil. Also, the Balance sheet would need to be declining at a moderate pace to offset a portion of that now “too easy” stance.