When Zero Hedge initially looked at the Taylor Rule Estimate for the Federal Fund Rate back in January, the prevailing consensus was that, even then, the Taylor-to-Fed Fund Differential was a whopping 6%. For those who wish to familiarize themselves with the Taylor Formulation, we suggest reading our initial thoughts, but in a nutshell Taylor's thesis is that the FOMC sets it fund rate target according to this rule:
where i is the nominal fed funds rate, r* is the equilibrium real funds rate, p is the inflation rate, p* is the Fed's desired inflation rate, y is the (log) level of real GDP, and y* is the (log) level of real potential GDP. (Various banks introduce coefficients that change the weighing of some of the factors, but in its purest, this is what the original Taylor formulation reads).The default calculation assumes a target inflation of 2% and unemployment rate of 5%.
Now of course only Sweden seems capable to pull of a negative Fund rate, which is why monetary policy is futile these days, and the only alternative the Fed has is to promote liquidity via Quantitative Easing.
So the question now is whether after several hundred billion of agencies, MBS and treasuries has already purchased, has the Taylor Rule estimate improved at least marginally, or, in other words, has the Fed Fund Rate to Taylor spread tightened.
The answer is an emphatic no, implying that in as much as QE was supposed to be the last bastion of monetary policy, it has failed, and all it has achieved has been to maintain interest rates on mortgages and bonds within a reasonable bracket. And as long as the money multiplier remains suppressed due to the population's perception of the true economy (which is surprisingly objective, despite the media's 24/7 propaganda that everything is now better), this negative metric will persist, and eventually force Bernanke to acknowledge that his monetary policy has been a failure.
The first chart demonstrates a time-study of the Fed Funds Rate superimposed on top of the Taylor Rule Estimate: According to Taylor if monetary policy had free reign, the Fed would need to set rates at -6.55% right now in order to stimulate inflation.
The 6.8% spread between the Taylor and the Fund Rate is the widest it has been in over 2 decades, while the actual Taylor reading is now the lowest it has been since data has been accumulated in the early 1980s.
So now that QE is gradually being unwound and various liquidity measures are starting the be reeled in by the Fed, the key question becomes just what weapon does the Fed have left in its arsenal to stimulate the monetary base in the hope of offsetting prevailing deflation and unemployment?
Alas, hope and green shoots do not work here.