The market's speculation of a Fed rate hike has accelerated since the beginning of June. Yields on two-year Treasury notes rose 44 bps on June 5 and June 8, marking the largest gains since September, while CBOT's Fed funds futures priced in a 70% chance that the Fed will raise interest rates in the November meeting. Although the yield has fallen since then, it still represented about 60% probability. Also, look at EUR/USD futures, for which the yield has picked up pronouncedly, implying the likelihood of tightening monetary policy in the US.


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Despite all this, we continue to believe that the Fed will keep its policy rate unchanged at 0-0.25% for the rest of the year with further QE policies in place.

In the minutes for the FOMC meeting on April 28-29, the Fed stated ".In these circumstances, the Federal Reserve will employ all available tools to promote economic recovery and to preserve price stability. The Committee will maintain the target range for the federal funds rate at 0 to .25% and anticipates that economic conditions are likely to warrant exceptionally low levels of the federal funds rate for an extended period." We expect that "an extended period" does not just mean for the "coming six to nine months," but at least until the end of 2010.

While it's true that recent economic indicators in the US and elsewhere have shown signs of stabilization, the economic backbone is still weak. Credits remain tight and the housing market continues to look gloomy. Recent increases in bond yield has been driven by ample Treasury supply and improved risk appetite. While the Fed has been trying to hold mortgage rates low, the rise in yields also poses risks to economic recovery.

The Fed bases on unemployment rate and core inflation to adjust monetary policies. These two indicators looked bad and will continue to worsen in the future.


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The Taylor suggests that given the current unemployment rate and inflation rate, the Fed funds rate should have been a -2.12% in 1Q09. After taking the Fed's forecasts on unemployment and inflation rates in the second half of 2009 and year 2010, the policy rates should continue to decline to as low as -5.5% in 4Q09 and remain negative throughout 2010 and 2011.

It's impossible for the Fed to reduce interest rates below zero, and therefore, the ZIRP has been accompanied by quantitative easing measures. Since the end of 2008, the Fed has expanded its balance so as to lower the costs and increase liquidity of the market. In the March meeting, the Fed announced a massive quantitative easing plan which includes purchase of up to $300B of long-term Treasury securities over the next six months, as well as expansion of the mortgage debt purchase program to $1.450 trillion in total, $1.25 trillion in agency MBS, up from $500B, and $200 billion in direct agency debt, up from $100B. In terms of overall size, the Fed's balance sheet has more than doubled to over $2 trillion. However, this can only represent part of rate reduction suggested by Taylor rule. Policymakers have already hinted that additional QE is likely by the end of this year.

Certainly, it's possible that the Fed's growing balance sheet will lead to inflation/hyperinflation. With higher inflation, the Fed will need to shrink the size of the balance or may need to tighten monetary policy (e.g. increase interest rates). However, it shouldn't be as early as the market speculated.


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NEXT: The Taylor Rule Explained |pagebreak|

What Is the Taylor Rule?

Proposed by John Taylor in 1993, the Taylor rule has been a popular tool to predict if or how much a central bank should change the short-term interest rate as the real inflation rate and/or real GDP diverge from the respective target inflation and potential GDP. In essence, the rule connects a central bank's target interest rate to GDP growth and inflation:

i=N + 0.5(Y-Y*) +0.5(P-P*)

Where i is the target short-term nominal interest rate; N is the neutral rate-the short-term interest rate that would be targeted if GDP growth were on trend and inflation on target-Y is the GDP forecast growth rate; Y* is the observed trend GDP growth rate; P is the forecast inflation rate; and P* is the target growth rate

The formula suggests that when the forecast GDP growth rate and /or the forecast inflation rate are above the trend or target level, short-term interest rates should be increased by half the difference between the forecast and the target and/or trend level. If the forecast GDP growth rate and /or the forecast inflation rate are below the trend or target level, short-term interest rate should also be reduced accordingly.

Another version of the Taylor rule equation is

i=N + a(P-P*) +b(U-U*)

Where i is the target short-term nominal interest rate; N is the neutral rate; a is the inflation gap coefficient; P is actual inflation; P* is the inflation target; b is the unemployment gap coefficient; U is the actual unemployment rate; and U* is the non-accelerating inflation rate of unemployment (NAIRU).

By ActionForex.com Staff