I was recently reading commentary on the question "is the Fed already behind the curve?". The Taylor Rule model was used to assert that the Fed has not cut far enough. The commentator used an approximate recent GDP growth rate of less than 1%, excess capacity and trend in core inflation to state that the Fed Funds rate should be nearer 1%. Quite alarming, it seems to me. What is your take on the Taylor Rule?

East Sider replies:

The Taylor rule works beautifully… in retrospect.

It requires precise estimates of things that are not observable — GDP trend, GDP slack, inflation — so it's useful only for ex-post criticism, not ex-ante policymaking. IMNSHO.

Another argument is often made based on 2 year treasuries trading nearly a full percentage point through 3% fed funds, with analysts saying this means "the market" is looking for the Fed to cut rates to at least 2 percent.

Professionals have wearied of pointing out the credit difference between an overnight unsecured interbank loan, and the perceived security of a liquid obligation representing the full faith and credit of the the US govt.

Comparing apples to apples at the front end of the curve - fed funds to two year swaps - it turns out Bernanke's shop may not be all that much of a laggard.

At Friday's close, overnight funds were roughly 20 bp higher in yield than 2 year swaps. Interestingly and counter-intuitively, that's spot on the one year moving average of that spread.

The market is certainly leading the Fed, but not by the scary-sounding distances usually cited. 


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