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Decoding the Federal Reserve: Unraveling the Speculation Surrounding Interest Rates

In this article, we dive into the intriguing and valid argument that the Federal Reserve may not need to tighten its monetary stance. We aim to highlight the rationale behind maintaining the status quo and evaluating data. Join us in exploring economic data points as we question the necessity of raising interest rates and contemplate the factors and influences around our Central bank's monetary policy.

Recently, there have been serious questions about whether the Federal Reserve has raised too much or even too little for our current economic growth and inflation rates. Strictly based on the data and the main formula-based approach the fed utilizes for finding target rates (The Taylor Rule), we find that target rates (around 3.9%) are currently much lower than our current fed funds rate (at 5.33%). The Taylor Rule is a monetary policy guideline suggesting that a central bank, like the Federal Reserve, adjust interest rates based on inflation and economic output. Named after economist John B. Taylor, the rule provides a systematic approach for central banks to balance stabilizing prices and supporting economic growth.


The Taylor Rules variables include neutral rates (the Fed never has an exact number on this, which is the most subjective variable), expected GDP, long-term GDP, expected inflation, and target inflation. For the sake of argument and the chance of worsening data, I will choose unfavorable estimates (which cause more upward pressure on the target rate):

- Neutral rate estimates by the fed are around 2.5% vs my estimate of 3.0%

- Expected GDP placed at 3.0%; Many are forecasting a low 1-2% (Atlanta fed @ 1.2%)

- Expected inflation is placed at 4.0%, the highest end of estimates for 2024 (currently at 2.5% for cpi)

- Considering the Fed's rhetoric, target rates are 2.0%


= Resulting in a target rate of 3.90%, significantly below our current 5.3%


Even with this higher-end inflation, neutral rate, and expected GDP estimates that I used, the target rates still come below our current range. Given that this method is the main way the Federal Reserve calculates the target rate, that I used above consensus estimates, and that rates have not been this high since 2008, I am confident enough to say the Fed is not going to raise without a significant change in inflation or economic growth (to the upside). Monetary policy is significantly restrictive, and no current and relative evidence supports further rate hikes. Furthermore, the fed can start cutting much sooner than they allude to.


Feel free to reach out or comment if you have any questions!

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Emon
Emon
18 déc. 2023

From forecasting one rate cut to three for 2024


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