Andrew Mccaffrey’s Excellent Interest Rate Question

Recently, in a post from 9/2 that seems to have disappeared, Andrew raised an interesting and timely question.  Here is what he wrote:

This post is as much about something that broke the ice in my head as much as it is a plea for help understanding finance.
In the August 8th issue of the Economist is this article about interest rates: http://www.economist.com/news/finance-and-economics/21660598-setting-interest-rates-according-fixed-formula-bad-idea-rule-it-out.
According to the article, the Taylor rule assumes the “long-run real interest rate” to be 2%. This baffles me, because according to my high school level understanding of finance, the federal funds rate is determined by the Fed, and all other interest rates are determined from that starting point. In other words, I understood interest rates to be entirely the result of a human decision made by the FOMC. So from where does this assumed “real interest ” behind the Taylor rule come?

With the Fed seriously pondering an interest rate hike for the first time in ten years, everyone wants to understand what is going on.  I will briefly cover the key points, but each is the subject of considerable debate.

  1. The FOMC determines the Fed Funds rate which is the short end of the yield curve (a chart of rates by length of the debt).  The yield curve can take many shapes from sharply sloping (normally a sign of robust economic growth and possible inflation) to inverted (a sign of a potential recession).
  2. The reason for the level of long rates at various levels is the subject of constant debate, including the following:
    • A term structure (closest to Andrew’s idea) where the short rate gets an increment for expected additional changes by the Fed, accumulating into higher rates for longer terms.
    • Expected future inflation – perhaps reflective of stronger economic growth.
    • Other Fed policies, like Quantitative Easing, which purchased longer-dated securities.
    • Market forces like demand from foreign nations, pension funds, or those fleeing riskier investments.
  3. A simple method like the Taylor Rule has become popular with those attacking the Fed’s continued stimulative policies.  Although Bernanke is a Republican, appointed by Presidents of both parties, his aggressive policies came under heavy attack by Republicans.  This has continued under Yellen.  This is business as usual for an out-of-power party — not just the GOP.

For more information on the Taylor Rule you should read Ben Bernanke’s blog post.  He is now a Distinguished Fellow in Residence (cool title) at Brookings.

For a lot more, and to improve your general knowledge about investing and financial markets, you might want to try out my weekly WTWA column.   Last week’s post emphasized the Fed, but I have taken up the issue many times.

I have been lax in contributing here to repay the enjoyment I have gotten from reading the posts of others.  I hope this evens the score a little bit.

Jeff

 

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