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- The Stock Market Looks Overvalued, but It's Probably Not
- China GDP Growth Surpasses Expectations
- President-elect Joe Biden Introduces His "American Rescue Plan"
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- Long Term Employment Shifts Caused by the Pandemic
- Earnings Provide Positive Surprise Despite Pandemic
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- Yellen Aims for Full Employment
- Minimum Wage Research in the Spotlight as a Hike Looks Inevitable
- Non-Residential Construction Soft in the Pandemic Economy
- Views on Interest Rates and the Move in Treasury Yields
- Inflation Indicators Healthy but Still on the Rise
- Risky Assets Sell-off Despite Optimistic Economic Outlook
- The Latest on Vaccinations and What it Means for Growth
- Highlights of the Fed's "Economic Well-Being of U.S. Households in 2020" Report
- Relative Factors and Forward Change in Federal Funds Rate
- Can Wage Growth Keep Up With Inflation?
- With That, We Carry On
- Supply Pressures Looking to Peak
- Cars are Still Expensive, Workers are Still Needed
- Recovery Continues, but Delta Looms
- Fed Eyes Tapering While China Sees a Setback
- Review the Fed Previews
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- Workers Find Leverage in a Tight Labor Market
- Cautiously Optimistic
- Sour Expectations Take Down the Market
- Q3 Earnings Were Surprisingly Good
- Inflation Weights on Bonds and Consumer Sentiment
- FOMC Tapers While Trade and Employment Flash Mixed Signals
- Inflation is Getting Broader, Not Cooler
- Unemployment Insurance During the Pandemic
- A Year of Normalization
- What Will GDP Growth Look Like in 2022?
Relative Factors and Forward Change in Federal Funds Rate
May 16, 2021
The Federal funds rate is an interest rate set manually by the FOMC Governors and five Federal Reserve Bank presidents. The group of monetary policy leaders analyzes the economic situation in the United States using a variety of indicators to monitor the labor market, financial stability, consumers and business spending, and much more. They are guided by a mandate set to maintain price stability and achieve full employment. As one might guess, the unemployment rate and inflation are both tracked closely, but how directly does the current state of these indicators affect the change in policy rates?
In this analysis, the current rate of unemployment and inflation is compared to the last year of each data point to get a standardized score that is used to try and predict the 12-month forward change in policy rates. The unemployment rate (UR) is the standard headline rate cited by the Bureau of Labor Statistics, and the inflation rate (INF) is the annualized PCE Price Index from the Bureau of Economic Analysis. The policy rate is the Federal funds rate. The standardized scores are also calculated using the last 12-months for the unemployment rate and annualized inflation rate.
The Federal funds rate (FFR) has very different relationships with the UR and the INF. The correlation coefficient for a simple linear regression model of the relationship between the FFR and the UR is an insignificant R = 0.03 showing no clear connection between the level of joblessness and where policy rates are set. On the other hand, the correlation coefficient for the FFR and INF model is much more robust at R = 0.76 suggesting it is a much larger determinant in how the Fed chooses interest rates. This may not be entirely the case. However, developed economies have adopted lower policy interest rates as their economies have entered deflationary periods. There was also a period in the 1970s where the setting of the FFR was sensitive to high rates of inflation rate during the Paul Volcker's tenure as the chair of the Fed.
Because of the Fed's mandate, one would expect 12-month forward changes in policy rates to be guided by these two variables. A qualitative overview reveals that positive changes in the FFR are associated with a UR that is lower relative to the previous year while negative changes in the FFR are associated with a UR that is higher relative to the previous year. Using the same method, no clear connection is established between forward changes in the FFR and a standardized IR. This is antithetical to the linear regression results highlighted in the paragraph before.
The scope of the backward looking standardization of UR and INF and of the forward looking change of the FFR does appear to matter. The data is parsed using three different time frames: 12-months, 24-months, and 36-months, and it is observed that the shortest time frame for both variables produces the strongest correlation for UR while the effect of the scope is less apparent in the INF. This suggests that more recent rates of unemployment are used to determine if the current UR calls for a change in policy rates.
There are some outliers in the data. In particular, some high standardized URs in the 1970s are associated with positive 12-month changes in the FFR. The US economy in the 1970s is associated with some of the highest rates of inflation even when the economy was stagnate with high levels of joblessness. In 1974, inflation was running over 12% and unemployment rate was over 7%. Likely, the Fed's focus switched from a full focus on the UR to managing the stagflation that was limiting growth. In 1978, the Full Employment and Balanced Growth Act established more firmly the dual mandate of achieving "full employment and price stability." Regardless, it's important to understand that in some cases the UR takes a back seat to INF if price levels get out of control.
With the pandemic behind, the Fed has indicated that full employment has become the guiding factor of Federal fund rate increases over the next few years. In doing so, they have backed away from the inflation targeting at 2.0% to allow for inflation to run above 2.0% for some time. The model built in this analysis, which is heavily affected by the UR, predicts a 0.26% increase in the Federal funds rate in the 12-months after February 2021. The model suggests that the UR has reached a level relative to previous months' UR that warrants a slight increase in interest rates. Of course, the Fed's dot plot suggests this is not in the cards, but market expectations have already started to shift with higher inflation in the latest April release. Even if rate hikes do come sooner than expected, job gains will need to impress the FOMC, otherwise, the hikes will be few and far between.