Fed funds rate with Taylor Rule implied

Let's take a look at the fed funds rate with implied Taylor Rule

Calculated as follows:

Taken from the St.Louis Fed website.

This is part of a post from here that you can read about. I am wanting to clarify what he has posted here that I hope will help someone with a very basic understanding of economics.

Take a look at this chart:

We have a lot going on here. Let's look at each one individually:
1) Fed funds (black line): The fed funds line you see here is the interest rate at which banks trade with one another, over night, using funds provided by the federal reserve--which acts as a primary lender. Generally speaking, the funds held at the federal reserve are only for the most credit-worthy depository institutions, and not just any bank. The fed funds rate influences both monetary and financial policy, which affects employment, growth, and inflation.

Currently, the federal reserve has been hinting at a rate hike, taking rates from near zero where they currently are to whatever number they want. It is most likely that they will increase the rate in small intervals so as not to shake the economy anymore than necessary. With an increase in the fed funds rate, generally speaking, comes at collapse, or at least modest decline in stocks; both price and volume, but is seen as a boon for bonds. Also, if you're an avid old-school saver, you will receive a higher interest rate on your bank deposits.

2) We have the Taylor Rule (red line): First, the Taylor Rule is a prediction here; predicting that when inflation is at target and the output is at potential (the output gap is zero), the FOMC will set the real federal funds rate at 2%, (the historical average), in this example 2.5%. The Taylor Rule is a guideline whose purpose is to describe the interest rate decisions of the FOMC.

The Taylor Rule was developed by Stanford economist John Taylor, which he describes it as being used as a "benchmark for monetary policy".

Here is the formula: r = p + .5y + .5(p – 2) + 2 (the “Taylor rule”)

where
r = the federal funds rate
p = the rate of inflation
y = the percent deviation of real GDP from a target

So on this it is important to explain that the feds target for real GDP is potential output; the amount the economy can sustainably produce when capital and labor are fully employed.

Looking at variably y in the Taylor rule, we can interpret it as being the excess of actual GDP over output, thus giving us the "output gap".

Using the Taylor Rule will lead us to predict that the FOMC will increase the fed funds rate (tightening of monetary policy) by one half of a percentage point (0.5%). It also predicts that when inflation is at target and output is at potential, the FOMC will set the real fed funds rate at 2%.

 This figure shows how monetary policy was too weak relative to using the Taylor rule for periods 2003-2005 and 2011. How do we know? By comparing the fed funds rate to the Taylor Rule, we see that the fed funds rate fell below the Taylor rule during those periods. Is that a good or bad thing? Well, mostly it doesn't matter, also this chart is from 2011, but I thought it both useful and interesting to use as we can see how the Brookings institute predicted the fed funds rate four years ago in comparison the the actual fed funds rate and the zero bound defined by the solid line.


3) Next, referring back to our second figure, we have the Taylor rule Laubach-Williams natural rate, the natural rate is assumed to change over time due to various unobservable influences.

4) The Wu-Xia shadow fed funds rate is not bounded below by zero percent, unlike many short-term models. In other words, it models what the fed funds rate would do negative interest rates were possible, using a host of historical macroeconomic data.

So now you're probably wondering what the heck all these models are doing on the same graph!?! It's simply giving us a comparison of what each model looks like given the same inputs. I like the Wu-Xia shadow myself, where it shows fed funds rates actually falling negative because it can be argued that it gives us a more accurate picture of whats going on in terms of monetary policy. That said, it, like many other models in economics can be argued against as well. It is currently not the model of choice for most economists, especially the feds, but it is considered a powerful representation of current macro policy; i.e. it's not as revered as the Taylor rule.

And finally, putting everything together, what does this tell us? This tells us that it is probably not the time for the feds to raise interest rates because the Laubach-Williams natural rate is 2.6% below the corresponding 2.5% equilibrium value derived on our Taylor rule (red) line.

Well I hope that was informative, if you have any questions please do not hesitate to ask!

The Experts vs. The Rest of Us

So finance is a science, right? Or is it an art? Either way, some individuals are clearly better at it than others. At least, in terms of money managers, investors, and analysts. Right? Well, I think it depends.

***My personal opinion**
From my experience in dealing with financial experts, and sort of being a "financial expert" myself ... that is without the incredible amount of wealth that normally seems to accumulate with most experts... I don't think there is much of a difference in the outcomes of an investors performance given their technical training (or lack there of). This extends beyond simple investing and into market forecasts and the prediction of large-scale economic events (such as a recession).

Check out these papers: here and here. To summarize both articles, they come to the conclusion that the experts are only "slightly" better at economic forecasting and at executing successful trades and investment decision making. There are actually more articles and papers on the subject that reinforce that statement that you can find through a Google search.

On an entirely theoretical scale, the reason why this seems to be the case is because markets are infamously tough to beat, and those that beat it, mostly beat it not because of any sort of magic, intensification of resources, or even because they're good at math and statistics; no. They beat the market because of two things: intuition, and guts.

Intuition may be attributable to some degree of luck, but you cannot make the argument that intuition itself is entirely luck, no. Most intuition comes from some level of knowledge of how markets work. Plain and simple. Maybe you have heard of Wave Theory, or maybe you haven't. A lot of folks I know have never heard of it yet, they're aware of it to some degree and that knowledge helps drive their investor sentiment. It helps guide them in what to buy, when, and for how long. These sorts of people notice trends before most other investors, and they also act much quicker than a similar person with an equal amount of knowledge, you might call it courage, fortitude, drive, whatever. The point is they are not afraid of execution.

That is most of investing.

Having spent most of my life working with math, especially the last seven years of it to very complex mathematical formulas and models, I can say with some degree of certainty that most successful investment strategies are more-so the product of intuition than they're good math. I can tell you what the price of a security should be, and how it should act under various situations and economic conditions, but I cannot tell exactly what will happen, even with perfect knowledge one slight change in a single variable will distort the entire investment environment.

That said, knowing the math can help. A great example of someone who is good with both math and at calling big economic events is Robert Schiller. But for everyday investment decision-making and money management, you don't need a highly polished educational background or to understand stochastic processes; no. You can simply observe trends, talk to your neighbors, and watch the news.

Again, these are my personal opinions based on my experience and knowledge. Feel free to prove me wrong with any number of papers and empirical facts, I would love that because I have yet to find any such paper.