Friday, January 16, 2015

December 2014 Inflation and an Adjusted Taylor Rule

YOY "Core minus Shelter" inflation is now down to 0.7%, and all of that came before June.  There has been no "Core minus Shelter" inflation since then.

A version of the Taylor Rule that I track (8.5% - 1.4*(Full Time Unemployment Rate - Core Inflation)) is still nearing 3%, because of strong employment trends.

This version of the Taylor Rule, as well as some others, looks like it tended to be too high in the 2000s, by as much as 2%, and now looks like it might be giving a reading that is still too high.  I have considered the possibility that real estate credit is the main governor on monetary growth right now, so that it may be that raising short term interest rates to 1% or 2% wouldn't have much effect on industrial credit.  But, wherever that number is, this version of the Taylor Rule still looks like it is too high by 1% to 3%.

I had been attributing this to broad secular trends, like the large pool of savings from developing markets and from aging developed world savers.  But, I wonder if part of this is due to the supply problem in housing.  The Taylor Rule treats inflation as a monetary phenomenon, so it might break down as a useful indicator if inflation is coming from a supply shock.

And, interestingly, adjusting this version of the Taylor Rule so that it uses "Core minus Shelter" inflation makes it conform much more closely to the interest rates of the last decade.  When the Fed pushed rates too far up in 2006, turning a plateau in homebuilding into a free-fall, the "Core minus Shelter" Taylor Rule avoids the error of treating the ensuing rent inflation as a demand issue.  We can see that here, as the adjusted Taylor Rule recommends a drop in short term interest rates by late 2006.

By January 2008, the adjusted Taylor Rule has reverted back to the regular Taylor Rule, but by then, rates were in free-fall, and the 1 year backward perspective of the rule would have been distorting its usefulness, as both indicators were negative by the beginning of 2009.

Rent inflation subsided briefly in 2004 and 2005, so that the Fed Funds rate trailed both of these indicators coming out of the previous recession.  Could it be that the core time period of the housing boom was the only time where homebuilding was actually able to meet demand?

The adjusted Taylor Rule is up to 1.5%.  Can I take this as evidence that my indifference to 2015 rate hikes is the correct approach?

If mortgage credit is normalized and equity recovery continues among existing homes, I would expect home building to rise steeply.  This will create new strength in employment and the new building will lower rent inflation.  This will cause these two Taylor Rules to converge, at a higher level.  Possibly this is an initial guide to the two scenarios for 2015 and these two Taylor Rules give an idea of where interest rates will peak, depending on what happens to the housing market.

If the Taylor Rule is useful at all, this might lend hope to the idea that, even if QE3 ended too soon and will lead to significant lingering disinflation, the economy will continue to rebound.  And, if some of the recent inflation softness is due to a positive supply shock in commodities, then both Taylor Rules would move higher.


  1. "If the Taylor Rule is useful at all, this might lend hope to the idea that, even if QE3 ended too soon and will lead to significant lingering disinflation, the economy will continue to rebound." - no, the Fed follows the market. Google Fischer Black and compare to Irving Fisher. At best a central bank can be a catalyst for market forces--at best--and typically only during good times. If people are fearful or don't want to invest for structural reasons, there's not much the Fed can do.