With another Fed cut likely, we compare how it has diverged from the Taylor Rule

Will the Federal Reserve announce another rate cut on Dec. 18? Futures markets think so. A framework for the Fed's policy challenge can be found in the economist John Taylor's rough guideline for where the interest rate "should" be over the short term.

Typical formulations of his rule include the concept of a “natural” or "equilibrium" long-term interest rate. Then, positive or negative "output gaps" and "inflation gaps" compare price increases to the Fed's target, and the economy's long-term potential to the current reality.

The Taylor Rule applies these inflation and output gaps to prescribe whether the Fed's key rate should be above or below the long-term natural interest rate.

As our chart shows, before the pandemic, the Taylor Rule (expressed as a dotted line) tracked the Fed's actual monetary policy relatively closely before the pandemic. But that all changed in 2020. The Taylor Rule suggests the Fed could have tightened policy to fight the post-pandemic inflationary surge much earlier than it did.

Following the output and inflation crash, the Taylor Rule started diverging from the Fed's ultra-accommodative policy as early as March 2021, and then surging as output rebounded and prices soared. By early 2022, a retrospective application of the Taylor Rule would have called for rates to reach a multi-decade high of 7.5% in March 2022 – the month that the Fed made its first hike from zero.

Subsequently, as inflation was tamed and output stopped overheating, the Fed could have been more dovish than it actually was from about mid-2023.

Of course, regardless of what the Taylor Rule might be showing, the Fed uses its own discretion to set policy based on real-time data, the stability of markets and the financial system, and its dual mandate of controlling inflation and promoting employment.

Our final two charts tackle the expected trajectory of rates through 2025. Estimates using the CME's FedWatch tool see the Federal Reserve easing from the current 4.5%-4.75% range to between 3.5% and 4% by the end of 2025.

For the December meeting, Fed funds futures are assessing roughly a 1-in-6 probability that the central bank holds rates steady. (Chair Jay Powell's recent comments have lacked some of their previous dovish overtones.)

For more methodology used in our first chart:

• Adjusted output gap is defined by actual output versus potential, as estimated by the Congressional Budget Office (CBO), before being multiplied by a coefficient of 0.5,
• Adjusted inflation gap is defined by core PCE inflation vs. the Fed's 2% target, before being multiplied by a coefficient of 0.5, and
• The Midpoint Fed Fund rate reflects the upper and lower limits of the Fed Fund target range.
• CEIC's estimate for the Taylor Rule implied rate assumes that the equilibrium rate is roughly equal to 2% throughout.

If you are a CEIC user, access the story here.