Where should interest rates really be?

By Jonathan Scheid

 23-Sep-1616-Sep-16Weekly% ChangeYTD% Change12 month %Change
S&P 500 Index 2,164.692,139.161.19%5.91%12.45%
Dow Jones Industrial Average 18,261.4518,123.800.76%4.80%11.93%
Nasdaq Composite 5,305.755,244.571.17%5.96%12.21%
Russell 2000 1,254.621,224.782.44%10.45%11.74%
MSCI EAFE (Intl.) 1,716.741,664.773.12%0.03%3.77%
10 Year U. S. Treasury Yield 1.62%1.69%-4.14%NANA
30 year U.S. Treasury Yield 2.34%2.45%-4.49%NANA

Last week, the Federal Reserve pleased global stock markets by leaving interest rates unchanged. The Fed felt that, even though the unemployment rate is low, the labor market still had some slack and that inflationary pressures were still not strong enough. In a nutshell, Chair Janet Yellen stated, “We judged that the case for an increase has strengthened but decided for the time being to wait for further evidence of continued progress toward our objectives.”

While stock investors like accommodative policy, savers continue to suffer from low interest rates on savings accounts and CDs. The Fed seems very set on avoiding an interest rate increase before the economy can handle it. This approach is understandable given the lengths that the Fed has gone through to help stabilize the economy since the Great Recession. Yet, extremely low rates aren’t good forever.

Given that the Fed has been and continues to hold down interest rates, we wonder where short-term interest rates should really be? To help answer that question we look at the work of economist John Taylor. Back in 1993, Dr. Taylor created an equation that helps identify the value of the federal fund rate—the short-term interest rate that the Fed uses to control the ease of access to money. The result of his equation is called the Taylor rule, and it is based on values of inflation and economic slack.

As we can see in the graph, the Fed has held their interest rate fairly in line with the Taylor Rule prescription until 2011. Around 2011, the Taylor rule indicated that the Fed should start increasing short-term interest rates to help control inflation and the economy. But the Fed didn’t act. In fact, the Fed released multiple rounds of quantitative easing to lower interest rates even further.

Currently, the gap between where interest rates are and where the Taylor rule says they should be is about 2.3%. According to the Fed’s own interest rate forecast (i.e., the dot plot), the Fed doesn’t expect short-term interest rates to go above 2% until 2019. Unless economic growth is consistently strong or inflation starts to appear, it is going to be a while before we see interest rates reach the level that the Taylor rule prescribes. Until then, it seems like lower for longer.

The views and opinions contained herein are those of Bellatore Financial, Inc. and have been researched and analyzed by Jonathan Scheid, CFA, President & Chief Investment Officer.

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