The Taylor Rule forecasts how much the Fed will cut interest rates?

Despite the lackluster performance of the US economy in 2023, it has demonstrated remarkable resilience to high interest rates, leading to a virtuous consumption-employment cycle that has propelled the economy forward. Meanwhile, global supply chains have exhibited unexpected endurance and adaptability, successfully adjusting to geopolitical tensions and economic changes. Notably, the surge in the field of artificial intelligence has become a major driving force behind the significant rebound in the stock market.

In early December last year, Powell still firmly held his policy stance, stating that "it's too early to speculate when the policy will loosen." Still, he quickly changed his tune on December 13, saying "The Fed will not wait for inflation to return to 2% before cutting rates, and emphasized the need to loosen constraints on the economy before reaching this point to avoid over-tightening." The contradictory statements have led many on Wall Street to believe that "central bank presidents have the right to publicly lie." Regarding rate cuts, some speculate that the Fed will cut rates by a total of 3 notches next year, while others are extremely optimistic, predicting a cut of up to 6 notches. Who is right and who is wrong? CPT Markets analysts mentioned the famous "Taylor Rule" as an important basis for analysis. The calculation method of this rule is:

Nominal interest rate = Long-term real interest rate + Actual inflation rate + 0.5 (Actual inflation rate - Target inflation rate) + 0.5 (Real GDP - Full employment GDP / Full employment GDP)

In response, CPT Markets analysts stated that although this formula may seem complex, it is actually quite easy to calculate. Below, they will explain it step by step to the readers:

1. Using the year-on-year core personal consumption expenditure price index as the inflation rate, and assuming that the Fed predicted an end-of-year inflation rate of 3.7% in September, while we assume a long-term real interest rate of 1%, the result obtained by plugging into the formula is 5.75%. Therefore, the Fed predicted at the time that there would be another rate hike in 2023, which should be appropriate.
2. Subsequently, as inflation quickly fell to below 3.5%, the interest rate level calculated by the formula at this time should be 5.45%, which is equivalent to the policy rate of 5.25-5.50% at that time. Therefore, the Fed did not raise interest rates at the November meeting.
3. When the November inflation rate fell again to below 3.2%, resulting in a much higher policy rate, this is also the main reason why the Fed made a major reversal in policy at the December meeting.

Overall, based on the latest economic forecast data released by the Fed, the calculated numerical result is 3.5%. Based on this result, it can be inferred that a rate cut of 6 to 7 notches next year may be an appropriate choice. However, CPT Markets analysts reminded readers that this is only an optimistic result based on theory. In reality, there is still a considerable contradiction between the Fed's interest rate forecast for next year, inflation, and economic growth forecasts, that is, unless there is clear evidence of economic deterioration, the actual extent of Fed rate cuts may be quite limited.

As for how the financial situation will be in 2024 and what impact it will have on the Fed's rate cut pace and frequency, investors must pay attention not only to the Consumer Price Index and Personal Consumption Expenditure Price Index but also to four important indicators proposed by CPT Markets analysts, to correctly assess whether the rate cut cycle is ready:

1. According to the PCE report, since September 2023, product prices have been trending downward, with a decrease of 0.7% in November. Still, service fees have continued to rise, increasing by 0.2% again in November. Although inflation has clearly cooled down, wage growth and rising service fees remain relatively active, which may hinder further inflation easing. Therefore, if the Fed wants to stabilize the current inflation situation, it must first successfully stabilize labor costs.
2. In addition to energy and food prices, housing costs have a high probability of driving another wave of inflation. However, whether house prices will fall depends mainly on whether the supply of houses for sale will increase. Due to high mortgage rates, many homeowners choose to retain locked-in low rates, resulting in their reluctance to sell houses. However, this situation is gradually improving, as the number of properties advertised on the Realtor.com website is steadily increasing, although it has not yet reached pre-pandemic levels.
3. Interestingly, if the public is worried about future price surges, they are more likely to prefer immediate consumption over savings, which may further fuel inflation. Therefore, evaluating people's views on short-term inflation is crucial. According to the latest data from the University of Michigan, consumers' expectations for inflation one year from now have dropped significantly, reaching their lowest level since March 2021.
4. When investors are worried about an economic downturn, they typically turn to safe assets, such as US Treasury bonds, causing bond prices to rise and yields to fall. For example, the yield on the US 10-year Treasury bond rose for most of the year in 2023, reaching nearly 5% in October, but has since fallen back. In addition, the spread between junk bonds and US Treasuries is seen as an indicator of investor concerns about debt defaults, and this figure is currently approaching historic lows.