Taylor-Rule Math May Help Explain Why Fed's Dots Spooked Markets

(Bloomberg) -- Federal Reserve officials pared back their projections Wednesday for interest-rate increases in 2019, and the stock market tumbled anyway. Investors may have been spooked after they double-checked the Fed’s math, according to Neil Dutta, head of U.S. economics at Renaissance Macro in New York.

Modern central banking mostly involves relying on estimates of the relationship between unemployment and inflation as a guide to setting interest rates. The famous “Taylor rule,” named after John Taylor, an economics professor at Stanford University, sums up the process.

In essence, Taylor’s rule says the central bank should set the interest rate based on an estimate of the “neutral” rate that neither speeds up nor slows down growth, as well as the distance of inflation and unemployment from their target levels.

Fed officials have publicly stated their target for inflation is 2 percent, and alongside their interest-rate projections -- published in the so-called "dot plot" -- they also produce estimates of the neutral interest rate and the “natural” rate of unemployment, which serves as the target unemployment variable in the rule.

The problem with the numbers published Wednesday, says Dutta, is that revised estimates for the neutral interest rate and the natural rate of unemployment, along with a downgraded inflation forecast, suggest policy makers should have reduced projected rate hikes from three to one, instead of from three to two. The new values reduce the Taylor-rule prescription for where rates should be by four tenths of a percentage point, according to Bloomberg calculations.

A few caveats are in order: U.S. interest rates are still below where the Taylor rule says they should be. Still, Fed Chairman Jerome Powell and his top lieutenants may be more attuned to changes in the prescriptions produced by rules like Taylor’s than the specific levels of those prescriptions.

Moreover, the projections don’t have names on them. It could be that even though the median estimate for something like the neutral interest rate or the natural rate of unemployment shifted between September and December, the views of those who matter most among the 17 participants did not.

Even so, Powell’s press conference -- which followed the release of the projections -- did little to reassure investors, who continued selling stocks throughout.

"The press conference, as it went on, actually eroded confidence," Dutta said. "When you say there are downside risks brewing, and yet you are going to hike at basically the same pace, that says you want the economy to slow down, to deal with an inflation problem that doesn’t exist."

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