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When Will the FOMC Turn From Dove to Hawk? Don’t Hold Your Breath…

September 3rd, 2009 Michael McDonough

Recently, concerns have been mounting over whether or not the Fed may need to consider a more hawkish stance over potential inflationary pressure.  Increments over the past several days in the price indices for both the Manufacturing ISM and Non-Manufacturing ISM have only exacerbated these worries.  To help quantify this situation I dusted off the old Taylor Rule, and constructed several scenarios, that could lead to an increment in the FOMC’s target rate.

For those of you unfamiliar with the Taylor rule, it is a tool used to estimate where the FOMC’s target rate should stand based on inflation and economic growth.  However, in my model instead of using actual GDP against potential GDP, I used the actual unemployment rate versus the non-accelerating inflation rate of unemployment or NAIRU; for this analysis I estimated NAIRU  at 4.5%. For the inflation component I used Core-PCE against the lower end of the Fed’s inflation threshold of 2.0%.   As you can see from the chart below, the model has quite accurately estimated the Fed Funds rate since 1990.

Source: St. Louis Fed

Source: St. Louis Fed

Source: My Calculations & St. Louis Fed

Source: My Calculations & St. Louis Fed

Presently, my model indicates the FOMC’s target rate should stand at -2.1%, which is more or less in-line with the Fed’s present range of 0% to 0.25% in addition to steps toward ‘quantitative easing’.  But, what type of scenarios could  place pressure on the Fed’s dovish stance?  First, lets start off with a highly unlikely scenario, leaving the Core-PCE constant, the unemployment rate would need to fall below 7.0% before my modified Taylor rule would indicate a Fed Funds Rate above 0.0%.  Alternatively, leaving unemployment constant at 9.4%, the model indicates Core-PCE would need to exceed 2.6% just to move the estimated target rate above 0%.  A more likely scenario would be an increase in the unemployment rate to 10%, which would place negative pressure on rates, coupled with a marginal increase in the PCE to 1.8%.  Using these inputs, my model signals a target rate of -2.2%.

What does this mean?  Given the current US macro-economic outlook it is very unlikely we will see any pressure on the Fed Fund target rate.  But, if there is a sharp unanticipated increments in core-PCE, there is a possibility the Fed could react regardless of the rule. The Fed is well aware of the damages prolonged excessive inflation–or deflation–could have on the US economy, and will react pro-actively to stem that risk .  Nevertheless, it is important to keep in mind that the Fed has a dual mandate to assure price stability and full employment.  Therefore, it is hard to believe the Fed would consider any deviations to its current policy while the country is experiencing rising unemployment, except in the most dire of circumstances.

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