I Hate To Say It, But Trump Is Right: Interest Rates Should Be Lower

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According to the famed economist John B. Taylor, two things matter when it comes to the Federal Reserve's benchmark interest rate, the Federal Funds Rate: inflation and GDP.

And Taylor should know. As the former U.S. Treasury Secretary for International Affairs and the creator of the Taylor Rule (a highly regarded monetary policy framework), he often has advocated for a more rigid and mechanistic methodology for regulating the U.S. policy rate.

On the latter (rigid monetary policy based upon his equation), the jury is still out, but on the former (the efficacy of theTaylor Rule), he’s, excuse the phrase, right on the money. 

At Atlas Analytics, we’ve run the regressions and can confirm that he’s correct: inflation and economic growth are the primary drivers of the Federal Open Market Committee’s (the board of the Federal Reserve responsible for monetary policy) benchmark interest rate.

Given we forecast GDP earlier and more accurately than anyone else in the world, we thought the time was ripe to offer our first forecast of interest rates, with somewhat surprising results.

Surprising Result 1: Trump Is Right. Interest Rates Are Slightly Higher Than Where They Should Be.

Take a close look at the headline graphic above. Zooming in on the right-end of the chart, we can see that our predicted Optimal Federal Funds Rate (the red line) is just below the actual Effective Federal Funds Rate (the blue line).

Wait, what are the Optimal Federal Funds Rate and the Effective Federal Funds Rate?

The Effective Federal Funds Rate (EFFR) is the volume-weighted median of overnight federal funds transactions. What the heck does that mean? It’s essentially the real-time trading price of the actual Federal Funds Rate, the U.S. central bank policy rate. 

So what is the Optimal Federal Funds Rate? Like the previously mentioned Taylor Rate, the Optimal Rate is where the Federal Funds Rate should be based upon prevailing GDP and inflation rates.

Think of it like our discussion of the fundamental value versus market price of an asset (for a refresher on this, read our article The Tale of Two Prices). Essentially, our Atlas Analytics’ Optimal Federal Funds Rate is the fundamental value, and the EFFR is the market price.

When the EFFR equals the Optimal Rate, the two are in balance; however, when there’s a dislocation (as there is now with the EFFR below the Optimal), then there’s potentially room for improved monetary policy to maximize the Fed’s dual mandate of full employment and stable prices.

How does this relate to Trump, and why is he “right”?

President Trump has not been shy about his admonishments of the Federal Reserve’s current monetary policy stance, calling for lower interest rates.

And, well, based on the graphic above, he’s actually right.

Currently the EFFR is hovering around 4.33% and, from our analysis, it should be around ~3.57%. 

(Note that the Taylor Rule calculation largely comes to the same conclusion, although it uses the natural logarithm of GDP while we use the growth rate).

Surprising Result 2: Interest Rates Are Likely Heading Lower In the Short Run.

Using the lag of the values to predict future Optimal Rates, Atlas Analytics projects that, in the short-run, interest rates will actually fall.

Why is this important?

We could give a long and erudite discussion of the transmission mechanism of monetary policy, such that the Fed’s short-term interest rate setting (i.e. the policy rate) permeates throughout the economy through various lending channels, suffice it to say that this means that auto loans, mortgage rates, and other forms of credit will decline.

But, as the great John Maynard Keynes quipped, in the long run, we’re all dead, so perhaps don’t hold your breath for 2% mortgage rates any time soon.

Surprising Result 3: The Post-COVID Inflationary Surge Wasn’t Sparked Only By COVID Stimulus. It Was The Result of Far Too Accommodative Policy Rates During the Mid-2010s.

The immutable Larry Summers coined the term to encapsulate the mid-2010s: “Secular Stagnation”.

During this period, advanced economies were all plagued with tepid growth and even more anemic inflation rates, so central banks around the world turned to increasingly accommodative monetary policy.

Did it work?

Up until COVID, not really. 

And then with the Pandemic, finance ministries flooded capital markets with helicopter money (remember those Biden-era Stimulus checks?), and central banks cut rates to nearly 0%.

Well, all of these policy responses definitely sparked the fire of inflation, but the tinder was already set, actually during the period of secular stagnation.

We can see this from the chart leading off this article.

For instance, EFFR was nearly at 0% from 2009 (following the tumult of the Global Financial Crisis) until 2016, when it should have been approximately 2.5%.

In essence, overly easy money in the 2010s ignited the early-2020’s inflation. The COVID-19 Pandemic was just the match.

Talk about a hot take…

In Conclusion

In short, Trump’s instincts on interest rates,  at least this time, aren’t entirely off base. According to Atlas Analytics’ model, the Fed Funds Rate is currently overshooting where it should be. Rates are likely to head lower in the short run, and the seeds of today’s inflation were sown well before the COVID-19 Pandemic in a decade of overly loose monetary policy.

At Atlas Analytics, we’re not here to score political points. We’re here to build better macro forecasts, faster, smarter, and more accurate than the consensus.

If you want to stay ahead of the Fed, not two months behind it, subscribe to our weekly updates.

We forecast GDP before the Fed does. Now we’re forecasting rates, too.