How Appropriate is Central Bank Policy

The FOMC and ECB are often criticized for being either too accommodative or not accommodative enough. The Fed funds target rate has been cut by 75bp and the more balanced outlook from the recent FOMC meeting initially prompted talk that the end of the mini-easing cycle was at hand. However, renewed concerns about the soundness of financial institutions prompted talk of further cuts. Meanwhile, in the eurozone, credit conditions have already caused the market to tighten for the ECB with euribor rates rising above the official refi rate. The ECB remains hawkish but we expect the ECB to remain on hold for an extended period.

One method for assessing the appropriateness of central bank policy is the Taylor rule. That rule was devised by economist John Taylor, who later became undersecretary of Treasury. It seeks to determine the appropriate level for Fed funds rate given potential GDP and targeted inflation. As An exercise, we applied the Taylor Rule to both the US and the eurozone.

Fed funds remain above neutrality; ECB’s refi remains slightly below neutrality

The outcome of the Taylor rule is dependent on its assumptions. Based on our assumptions presented below, the Fed funds rate remains some 50bp above neutral while the ECB’s refi rate is just 15bp below neutral and the market has already adjusted the euribor rate to neutrality. While central banks can under or overshoot the neutral rate in their tightening/easing cycles, the outcomes suggest that the Fed has more scope to cut rates and that the ECB is likely at the end of its tightening cycle.

We continue to see a risk that the Fed cuts rates in December. We think the risk is the US economy slows below 2.0% in Q4 but that the economy stabilizes in Q1 ‘08. At the same time, we think the ECB has finished its tightening cycle and that the current tightness caused by the credit markets and the strength of the euro will help to slow the eurozone economy. We expect these shifts in trends will give the dollar better traction by the end of Q1 08 or early Q2.

Assumptions for calculating the Taylor rule

The Federal Reserve, unlike most central banks, does not have a formal inflation target. We calculated the neutral rate using both the ceiling and midpoint of the Fed’s unofficial inflation target. We also used three different measures of inflation, the Fed’s preferred inflation measure, the core-PCE, as well as core CPI and also headline CPI. We assumed potential output was 2.75% to 3% and used a survey of economists’ estimates for annualized Q4 GDP of 1.8%. We applied the Taylor rule to each possible data point and took an average of those outcomes to produce an average rate of 4.0%.

The ECB calculation was more straightforward though we acknowledge that the ECB and Fed have slightly different monetary policy objectives. We used the ECB’s inflation target ceiling and the Bank’s inflation measure, HICP CPI. We assumed potential output at 2% and again used a survey of economists estimate for annualized Q4 GDP of 2.0%. That produced an equilibrium rate of 4.15%, slightly above the 4.0% refi rate but equivalent to the one-month euribor rate.

Events to Monitor Going Forward

We think the key factors that investors ought to monitor going forward are the health of the US financial system, the pace of decline in the housing sector and risks to the US economy. The full extent of the CDO impact on balance sheets of financial intermediaries (not only banks, but brokerages and insurance companies) is not fully known, nor is the systemic risk that this may pose. Many industry insiders are not looking for a recovery in the housing market until the latter half of 2008 and into 2009. There are large amounts of adjustable rate mortgages that need to be reset in the coming months. Every end of the housing cycle in the US has coincided with the end of the business cycle. The key issue is whether this cycle could be different. Thus far evidence suggests that the impact of the housing market recession is limited to related industries with other sectors like exports countering the weakness. The US consumer has served as ballast for the economy encouraged by job and income growth.