By: Tom Goodwin, PhD, Senior Research Director
The long, long drum roll has stopped and the Federal Reserve has finally begun raising its key interest rate for the first time in nearly a decade. On December 16 it announced a 0.25% increase to a range of 0.25-0.50%. Market participants are now trying to get a sense of how far and how fast the rate rise might go.
In an effort to shed light on the rate setting process, Professor John Taylor of Stanford University developed a simplified rate calculation that tracks the history of rate setting remarkably well, suggesting there is a rules-based component to policy deliberations. But times such as the present--when the Taylor Prescribed Rate doesn't track the actual Fed Funds rate--can be even more illuminating.
The “Taylor Rule,” as it has come to be known, is a simple mathematical formula that calculates a rule-based prescribed policy Fed Funds rate based on the Fed’s twin policy goals of inflation and unemployment:
The approach is straightforward: a neutral policy rate of 4.0% (2.0% real return to capital + 2.0% inflation) is the rate prescribed when inflation and unemployment goals are reached. Deviations from this rate are driven by inflation and unemployment gaps. For every percentage point that “core” inflation (all items except food and energy) is above (below) the inflation target of 2.0%, the prescribed rate is increased (decreased) by 1.5%. For every percentage point actual unemployment is above (below) target unemployment of 5.0%, the prescribed rate is decreased (increased) by 1.0%.
These parameters aren't arbitrary--they're the assumptions most often used by economists. And the chart below illustrates that historically this calculation hasn't been too far off the mark, at least from a directional standpoint.
As pictured, the Taylor Prescribed Rate roughly describes the actual Fed Funds rate prior to 2009, with some departures. Deviations are most noteworthy at the beginning of the last three recessions, when the Fed acted more quickly to lower the rate than the Taylor Rule would prescribe. And in the case of the 1990 and 2001 recessions, the Fed lowered the rate further than prescribed by the Taylor Rule to stimulate a recovery. But aside from these differences, up until 2009 the Taylor Rule appears to be a useful guide for tracking the Fed funds rate.
The period thereafter tells a different story. The sharp divergence between the Taylor Rule and the Fed Funds rate began in 2009, when the unemployment rate peaked at 10%. And while this led to negative rates prescribed by the Taylor Rule, the Fed could only lower the Fed Funds rate to zero–as low as conventional monetary policy would allow. This of course gave rise to the array of unconventional policies known as “quantitative easing.”
As economic indicators have since improved, the Taylor Prescribed Rate has risen commensurately, reaching a level that is close to the “policy neutral” rate of 4.0%. Yet the Fed Funds Rate has flat-lined, hovering steadfastly near zero.
The resulting divergence between the Taylor Prescribed Rate and the actual Fed Funds rate suggests there has been a growing pressure to raise rates. The current large gap between the Prescribed Rate and the current Fed Funds rate provides some context for market observers when assessing the latest “lift off” and future likely moves by the Fed.
 Taylor, J. (1993), “Discretion Versus Policy Rules in Practice,” Carnegie-Rochester Conference Series on Public Policy, 39, 195-214.
 Rosenberg, M. (2010), “Fed Funds Rate Outlook – A Taylor Rule Perspective,” Bloomberg Financial Conditions Watch, 27 January.
© 2015 London Stock Exchange Group companies.
London Stock Exchange Group companies includes FTSE International Limited (“FTSE”), Frank Russell Company (“Russell”), MTS Next Limited (“MTS”), and FTSE TMX Global Debt Capital Markets Inc (“FTSE TMX”). All rights reserved.
“FTSE®”, “Russell®”, “MTS®”, “FTSE TMX®” and “FTSE Russell” and other service marks and trademarks related to the FTSE or Russell indexes are trade marks of the London Stock Exchange Group companies and are used by FTSE, MTS, FTSE TMX and Russell under licence.
All information is provided for information purposes only. Every effort is made to ensure that all information given in this publication is accurate, but no responsibility or liability can be accepted by the London Stock Exchange Group companies nor its licensors for any errors or for any loss from use of this publication.
Neither the London Stock Exchange Group companies nor any of their licensors make any claim, prediction, warranty or representation whatsoever, expressly or impliedly, either as to the results to be obtained from the use of the FTSE Russell indexes or the fitness or suitability of the indexes for any particular purpose to which they might be put.
The London Stock Exchange Group companies do not provide investment advice and nothing in this article should be taken as constituting financial or investment advice. The London Stock Exchange Group companies make no representation regarding the advisability of investing in any asset. A decision to invest in any such asset should not be made in reliance on any information herein. Indexes cannot be invested in directly. Inclusion of an asset in an index is not a recommendation to buy, sell or hold that asset. The general information contained in this publication should not be acted upon without obtaining specific legal, tax, and investment advice from a licensed professional.
No part of this information may be reproduced, stored in a retrieval system or transmitted in any form or by any means, electronic, mechanical, photocopying, recording or otherwise, without prior written permission of the London Stock Exchange Group companies. Distribution of the London Stock Exchange Group companies’ index values and the use of their indexes to create financial products require a licence with FTSE, FTSE TMX, MTS and/or Russell and/or its licensors.
The Industry Classification Benchmark (“ICB”) is owned by FTSE. FTSE does not accept any liability to any person for any loss or damage arising out of any error or omission in the ICB.
Past performance is no guarantee of future results. Charts and graphs are provided for illustrative purposes only. Index returns shown may not represent the results of the actual trading of investable assets. Certain returns shown may reflect back-tested performance. All performance presented prior to the index inception date is back-tested performance. Back-tested performance is not actual performance, but is hypothetical. The back-test calculations are based on the same methodology that was in effect when the index was officially launched. However, back- tested data may reflect the application of the index methodology with the benefit of hindsight, and the historic calculations of an index may change from month to month based on revisions to the underlying economic data used in the calculation of the index.