Sunday, October 14, 2007

The Fed Hasn't Cut Real Rates, Yet...

Do you want a hint as to what the Fed will do at the next FOMC meeting? You're in luck because Ben Bernanke just gave us a big one in his opening remarks at the conference on John Taylor's Contributions to Monetary Theory and Policy:

The Taylor rule also embeds a basic principle of sound monetary policy that has subsequently been referred to as the Taylor principle. According to this principle, when a shock causes a shift in the inflation rate, the central bank must adjust the nominal interest rate by more than one-for-one. This ensures that the real interest rate moves in the right direction to restore price stability.
That doesn't sound like much of a hint, I know, but read on.

The Taylor principle says that when inflation rises, the Fed should raise nominal rates by more than the increase in inflation, so that real rates go up too. Conversely, when inflation falls, the Fed should cut rates by more than the fall in inflation, so that real rates decline. Bernanke, above, calls the Taylor Principle "a basic principle of sound monetary policy." Frederic Mishkin called it a "key principle" in a recent paper. Don Kohn, in a 2005 speech, called it a "basic precept, embraced by central bankers everywhere."

So with that in mind, let's revisit a passage from Janet Yellen's speech earlier this week:
Over the past twelve months, the price index for personal consumption expenditures excluding food and energy, or the core PCE price index, has increased by 1.8 percent. Just several months ago, the twelve-month change was quite a bit higher, at nearly 2½ percent. It wouldn’t surprise me if core PCE price inflation edged down a little bit more over the next few years.

[I] considered the larger-than-usual cut in the funds rate prudent because... the stance of monetary policy... was growing more restrictive as core inflation gradually trended down.
Well that's quite interesting. Let's take a look at the data. The graph below (click to enlarge) shows several key interest rates, all deflated by the year-over-year change in core PCE. The top two lines are real mortgage rates for conforming and jumbo mortgages. Those rates are significantly higher than they were at the start of the year, adding to downward pressure on real-estate prices. The lower two lines are overnight LIBOR and the Fed funds rate, again both significantly higher than at the start of the year, and still firmly in restrictive territory.

The reason is that core YoY PCE has fallen by about 65 bps since the Fed stopped raising rates last July. The recent trend is even steeper. The 6-month annualized PCE deflator has fallen by 130 bps over that same period, implying the YoY rate will continue to fall:
That puts the Fed, according to their own Taylor Principle that's "embraced by central bankers everywhere", pretty far behind the curve. So can someone explain to me again why the market isn't expecting another rate cut on October 31st?

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