Will Taylor rule?
Investors are constantly trying to judge the so-called “reaction function” of the Federal Reserve to understand the likely path for monetary policy. This understanding could get turned on its head in the next twelve months if Janet Yellen is replaced by Professor John B Taylor of Stanford University.
The 1977 Federal Reserve Act requires the Fed to set policy in such a way as to “promote effectively the goals of maximum employment, stable prices and moderate long-term interest rates”. However, it is silent on how the Fed is supposed to operate to achieve these goals.
In practice, Federal Reserve decision-making is based on a system of debate and discretion. In the past, this process was shrouded in mystery. Alan Greenspan, Chair of the Federal Reserve from 1987 to 2006, once half-jokingly quipped:
Innovations over the last couple of years (explicit forecasts, an inflation target, dotplots and press conferences) have made it much more transparent. However, there is still no hard and fast rule that determines how policy should be set.
But there could be …
Janet Yellen’s term as the chair of the Federal Reserve comes to an end in January 2018. It is perfectly possible that she is offered (and accepts) another term of office. But if not, the markets will have to adjust rapidly to the new boss's way of thinking.
One name in the mix is Professor John B Taylor of Stanford University. He has solid Republican credentials, having served as a member of the President’s Council of Economic Advisors (1989-91) and Undersecretary of the Treasury for International Affairs (2001-05). Moreover, as one of the ten most widely cited macroeconomists in the world, no-one should doubt his academic credentials.
He is on record as believing that:
Consistent with that, the Taylor Rule to which he gave his name is a fairly prescriptive mapping from key economic variables (inflation, unemployment) to policy.
So what would it imply today? The chart below updates work first published by the Federal Reserve Bank of San Francisco in 2009. It applies a fairly standard Taylor Rule to the Fed’s own forecasts of core inflation and unemployment, taking into account their current estimate of neutral rates at 3%.
The conclusions are fairly stark. On a Taylor principle, interest rates would be around 2% today (rather than languishing close to 50bps). By the end of 2018, with core inflation back to target and an unsustainably tight labour market, they would be above 3.5% (compared to just 1.6% currently priced into the futures market).
Even a whiff of interest rates at these levels would represent a fairly seismic shock to markets. The discount rate used to value all financial assets would adjust abruptly higher implying the potential for significant short-term losses.
This fact alone suggests that Chairman Taylor might take a rather more pragmatic approach to setting monetary policy than that advocated by Professor Taylor. However, investors have a nasty habit of selling first and asking questions later.
Succession planning at the Federal Reserve may not be the most high profile item in Donald Trump’s in-tray, but for financial markets in 2017 it could be one of the most important.