Is The Federal Reserve Really Just Winging It?

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FOMC indicated its using data to determine to rate interest rates, but it hasn't.

The Taylor model was a good indication of where Fed funds rates should be, based on key economic data.

The Fed isn't being transparent and doesn't know which way it's headed.

The Federal Open Market Committee is scheduled to commence its two-day meeting on September 20-21, 2016. With that said, the markets are trying to figure out what the Fed will decide to do with Fed funds rate. The SPDR S&P 500 Trust ETF (NYSEARCA:SPY), the SPDR Gold Trust ETF (NYSEARCA:GLD), the iPath S&P 500 VIX Short-Term Futures ETN (NYSEARCA:VXX) and the iShares 20+ Year Treasury Bond ETF (NYSEARCA:TLT) should see heightened volatility heading into the meeting.

Global markets are not looking forward to the next big indication of where the economy is heading. Markets are only placing an 18% probability of a Fed funds rate hike in September. However, there will be some key points noted in the meeting that market participants should be focused on. Specifically, the job market and inflation. Any statements made regarding a rate hike later this year should shake markets up. The implied probabilities of November and December rate hike are 26.8% and 51.2%, respectively.

Source: Bloomberg

Dot plots could be the best indication of where interest rates could be headed. The dot plot is published after each FOMC meeting and depicts the projections of FOMC members. Each dot indicates one member's view on where the fed funds rate should be at the end of the calendar year.

By the end of 2016, all FOMC members are expecting for rates to be higher than the current target rate of 0.25 - 0.50%. Although the dot plot is a good projection of where rates are headed, there's no telling what the FOMC will do in its September meeting. It's a wait and see game. However, there are some useful tools, such as the Taylor model, that could give a good indication of what the FOMC should do given the state of the economy.

Source: Bloomberg

Using Taylor Model and Evans for For Future Fed Funds Rate Estimates

The Taylor Rule, or Taylor model, is used to forecast interest rates. The model was created by John Taylor in the early 1990s. In mathematical terms, the Taylor rule looks like this:

Fed Funds Estimate = r* +pi +alpha*(pi -pi*)+(Beta*Okun*(y-ŷ))

Using Evans rule, named after the ninth president and CEO of the Federal Reserve Bank of Chicago, and the above equation, r*is the neutral real Fed funds rate, pi is the core personal consumption expenditures (PCE) prices excluding food and energy prices and pi* is the target inflation rate. Additionally, beta is a constant given to the unemployment gap, (y-ŷ), and Okun is the constant factor given to convert the unemployment gap to the output gap.

The core PCE measures the prices paid by consumers for goods and services excluding the volatility caused by movements in food and energy prices. Therefore, the core PCE provides a good measure of underlying inflation trends. With the Fed placing more weight on inflation and unemployment to determine whether it should raise rates, the Taylor model, using Evans rule, provides a good estimate of potential future Fed funds rates.

Below are the figures used to calculate the estimate for where Fed funds rate should be, based on Evans rule. Evans rule stated that the Fed funds rate will remain low until unemployment falls below 6.5% or inflation rises above 2.5%. However, the FOMC removed the explicit thresholds in 2014, but emphasized there is no change in the stance of monetary policy at the time. Now, just because the FOMC is not using Evans explicit rules, it still provides a good estimate of Fed funds rate in the future, as shown in the figure below.

Source: Bloomberg

Source: Bloomberg

Now, as shown in the figure below, the Taylor rule, used with many variants of interest rates, has been shown to depict the trend of the real effective fed funds rate properly, prior to 2007. The change of the global economy and the global recession caused the Taylor rule to differentiate significantly from the real effective funds rate. However, the Taylor rule with a fixed neutral rate still followed the fed funds rate with the least error.

In theory, since the FOMC indicated that it would raise rates based on the trends of inflation and jobs growth, the Evans model should depict the real effective funds rate properly. With the strong trend of jobs and housing markets, the Fed should have raised rates multiple times this year, even with the market selloff in early 2016.

The Federal Reserve doesn't seem to be relying on macroeconomic trends anymore, based on these facts and figures. Looking at the timeline below, Federal Reserve members have been contradicting economic policy. Some FOMC members advocated an interest rate hike due to strong economic data, while others advocated a more dovish stance and did not believe in the strength of the U.S. economy.

For example, Kansas City Fed President Esther George has taken a more hawkish stance and believed it was time for an interest rate hike in 2016 due to strong U.S. economic data. Conversely, Governor Daniel Tarullo was in no hurry to hike rates, in August 2016. It seems like some FOMC members are not seeing the same U.S. economic data and trends. Some FOMC members have a neutral stance, and it doesn't seem like they really know what to do, in regards to raising interest rates.

Sources: Ben Bernanke Oct. 2012, Jeffrey Lacker April 2015, Esther George July 2015, Loretta Mester August 2015, October 2015 FOMC Minutes, Eric Rosengren May 2016, Daniel Tarullo June 2016, Esther George August 2016, Lael Brainard September 2016

If the FOMC is not using the Evans rule, which takes into account unemployment and inflation, there's no telling what the FOMC is collectively looking at to raise rates. It almost seems as if the FOMC is just winging its meetings and not really looking at U.S. economic data to determine its interest rate policy.

The Bottom Line

That being said, there's no telling what the FOMC will do in its September 2016 meeting. The probability of the Fed increasing rates in September is just 18%, and it will most likely opt for a rate hike later this year, and not in September. However, that doesn't mean there won't be some action heading into this event.

The FOMC says that its decision to raise rates is dependent on economic data. Looking at the comments over the past two years, that's not the case. The Fed has been flipping back and forth and is not being transparent.

What is the Fed going to do in September 2016, or even this year for that matter? Honestly, your guess is as good as mine. It's quite clear what the Fed is saying is completely different from its actions. It almost seems as if the FOMC is more concerned about spooking the markets than making decisions based on clear-cut facts and economic data.

Some key things to watch out for in the market are ETF options. As of the afternoon on September 16, 2016, for options expiring on 9/23/2016, the market was implying these moves based on the At-The-Money straddles: 1.35% in SPY, 1.9% in GLD, 1.70% in TLT and 1.3% in the PowerShares DB USD Bull ETF (NYSEARCA:UUP).

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 (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.

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