Predicting Changes In The Federal Funds Rate - The Magic Indicator

by: Jonathan Selsick

Summary

The Taylor Rule is the most widely accepted indicator for predicting the Federal Funds Rate or explaining the interest rate decisions of the Federal Open Market Committee (FOMC).

We present another indicator - the rate of change of productive assets - that better describes FOMC decisions and does not require any of the assumptions required for the Taylor Rule.

When combined with a revenue indicator it gives insights into all aspects affecting Fed policy and the Federal Funds Rate.

Combining these two indicators into an asset turnover ratio provides a key measure of the health of the economy and tends to lead changes in the Federal Funds Rate.

We provide a series of charts to explain our thesis.

The Indicator

The indicator we present is the year-over-year percentage rate of change in per capita Nonfinancial Corporate Business, Nonfinancial Assets at Historical Cost. It used to be referred to as "Tangible Assets Stated at Historical Cost" -- it includes real estate, equipment, intellectual property products and inventories. Think of it as productive assets of nonfinancial corporations. It does not include financial assets.

We look at it on a per capita basis; in other words, the per capita value of productive assets that corporations have on their balance sheets. We then transform this by calculating the year-over-year percentage rate of change in productive asset accumulation.

Observe in this chart how closely it tracks the Federal Funds Rate.

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How does it compare to the Taylor Rule?

This chart shows our measure (in red) compared to the Taylor Rule measure (in blue). Our measure has a slightly higher correlation with the actual Federal Funds Rate over the entire period shown starting in 1955. The Taylor Rule did a little better than our measure up until 1982, but our measure has been more accurate than the Taylor Rule since 1982.

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The Taylor Rule requires making assumptions for an inflation target, the natural real interest rate, and an estimate of full output (normally gross potential GDP) needed to measure the output gap. Charles Plosser, President of the Philadelphia Federal Reserve Bank, has previously discussed the problems encountered in trying to measure output gaps, and talks in favor of using some measure of actual economic growth -- but does not provide any suggestions as to which measure to use.

It is interesting that our measure, which is a very specific measure of economic growth, does a slightly better job of predicting the Federal Funds Rate, but does not require making any assumptions at all. And the fact that it matches up on the same scale as the Federal Funds Rate seems remarkable.

The logic behind the indicator

Why might our indicator predict FOMC actions? Well, remember that the FOMC's objective is to moderate the business cycle to maintain stable employment and inflation, and it does so by adjusting the short term interest rate. If the economy is growing too fast, then it raises rates to slow it down and vice-versa.

Our indicator represents the rate of change of productive assets that corporations are putting to work. If growth is strong and corporations expect continued growth, then they will invest in more productive capacity to meet the expected demand. So corporate investment in productive assets is simply a very good proxy for growth and growth expectations, which is exactly what the Fed tries to moderate.

Adding another measure of growth

Like the Taylor Rule, our measure has been inconsistent with actual FOMC decisions since 2009. To help understand what is going on we look at the Gross Value Added of Nonfinancial Corporations -- essentially their GDP or top-line revenue.

This chart show the year-over-year change in Gross Value added against the change in the Federal Funds Rate. Simple observation confirms that these two are highly correlated. Note the declining rate of growth since 2011 -- a troubling sign.

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A growing productive asset base with declining revenues is a recipe for recession

Dividing the Gross Value Added by Nonfinancial Assets (we will refer to it as Sales/Assets or Asset Turnover ratio from now on), it is currently at 68% (left hand scale) which is lower than at any previous time in history, except for the Great Recession, and has been in a decline for the past thirty years. Note how low points in this measure correspond with recessionary periods.

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This decline is further reflected in declining capacity utilization.

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A good measure of overall economic activity

Year-over-year changes in the asset turnover ratio is probably the best single indicator we have seen for understanding the health of the economy and the likely path of FOMC rate decisions.

Before we show how it tracks the Federal Funds Rate, note how it tracks nicely with the Chicago Fed National Activity Index (CFNAI) which is a broad measure of economic activity comprising some 80 different indicators -- so our simple indicator does a good job here too. Note the divergence from the CFNAI since 2011 as well.

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Sales/Assets trend seems to lead Fed activity

Looking at the same year-over-year asset turnover indicator against the Federal Funds Rate, notice how our measure tends to lead FOMC decisions by one or two quarters, highlighting how powerful this indicator is. The correlation actually improves when we lag the Federal Funds rate by one or two quarters. We think this is a very valuable indicator to keep your eyes on. We maintain a current, updated version on our homepage which you can reference in the future if you don't wish to re-create the chart yourself.

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Tracking unemployment and inflation - the two key components of the Fed mandate

Unemployment

Asset turnover trend and unemployment change have a strong negative correlation. Since 2014, the unemployment rate has been improving, even though the asset turnover ratio has been declining; however the rate of improvement in employment is slowing - it's close to crossing the zero line. This indicates that unless top line growth starts to pick up, the recent improvement in the unemployment rate may be temporary.

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Inflation

Change in asset turnover and change in 10-year inflation expectations since 1982 are based on the Cleveland Fed's 10-year inflation estimates. As with unemployment, there is a slight divergence from historical trend between the recent asset turnover rate and the inflation expectations. Current 10-year expected inflation is 1.69%, which is below the Fed's target of 2%, and according to this chart, might be headed still lower.

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Our assessment of these indicators

Combining the two measures syncs with all the variables that the FOMC looks at, and gives a excellent perspective of how the economy is performing.

The FOMC has allowed productive asset growth to continue without a Federal Funds Rate raise for longer than would have been predicted by our productive assets indicator; however the growth of those assets occurred without a matching increase in top-line growth. If investment in productive assets continues to grow at a faster pace than top-line growth, that will only exacerbate the problem and push it further down the road.

Unemployment and inflation are now close to target; however the asset turnover ratio is signaling weakness ahead for sales, which in turn will affect unemployment and inflation. This presents a real predicament for the Fed and highlights why there is division within the FOMC right now -- it's just not a clear picture. It confirms why Chair Yellen has reiterated many times that current policy is "data dependent."

Usefulness of these indicators for Fed policy

The productive assets rate of change and the asset turnover ratio are both very powerful indicators -- and meet Charles Plosser's criteria of being real measurable economic variables.

In a March 2015 speech, Chair Yellen provided a useful assessment of how she thinks about the Taylor Rule, which is worth quoting in its entirety to assess how she thinks about simple rules like we have presented -- highlights are mine:

Under normal circumstances, simple monetary policy rules, such as the one proposed by John Taylor, could help us decide when to raise the federal funds rate. Even with core inflation running below the Committee's 2 percent objective, Taylor's rule now calls for the federal funds rate to be well above zero if the unemployment rate is currently judged to be close to its normal longer-run level and the "normal" level of the real federal funds rate is currently close to its historical average. But the prescription offered by the Taylor rule changes significantly if one instead assumes, as I do, that appreciable slack still remains in the labor market, and that the economy's equilibrium real federal funds rate--that is, the real rate consistent with the economy achieving maximum employment and price stability over the medium term--is currently quite low by historical standards. Under assumptions that I consider more realistic under present circumstances, the same rules call for the federal funds rate to be close to zero. Moreover, I would assert that simple rules are, well, too simple, and ignore important complexities of the current situation, about which I will have more to say shortly."

Clearly, we should not expect to see the Fed to rely on any one indicator, but it would be interesting to hear Chair Yellen's take on why her policy stance currently differs from the recommended path of our output-based indicators, as opposed to the explanation above for the deviation from the Taylor Rule.

Disclosure: I/we have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours.

I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it. I have no business relationship with any company whose stock is mentioned in this article.