The Taylor rule is a method for determining how much the Fed should raise or lower rates based on inflation and the difference between real and potential GDP (also known as the output gap). The underlying premise is that the Fed raises interest rates to curb high inflation and lowers interest rates to spur a slowing economy.
The formula, taylorOutputGap, is defined below.
Another way of looking at the Taylor rule is to use Okun’s law, which gives a better model for the Fed Funds target rate. Okun’s law states that for every 1% increase in unemployment, there is a 2% or 3% output gap.
Here we look at a similar formula to above that uses CPI and Okun’s law to get our new formula, taylorOkun.
The Chart below shows the Fed Funds Target Rate (orange) against the traditional Taylor rule formula (blue) as well as the revised, Okun’s law version (green). The subcharts show that the revised Taylor rule is generally closer to the Fed Funds Target rate than the traditional Taylor rule.
Our goal is to find the times when the Fed Funds target rate is too low (ie our model is above the target rate) or when the target rate is too high (our model is below the target rate).
Using Date Set, here are the dates when the Fed Funds rate is at least 1% too low:
Finally, we measure market performance when Fed Funds rate is too high or too low. The tables show the annualized returns of hte S&P 500 (since 1987) and each SPDR fund (since 1999) during times when the Taylor Rule was X% above or below the Fed Funds Target Rate.
What we find here is that the market performs significantly better when our model is below the target rate. In fact, all of the sector SPDR funds recorded negative returns when the Fed Funds rate was .5% too low, 1% too low, and 1.5% too low. On the flip side, only 3 sectors recorded negative returns when the fed funds rate was .5% too high or higher. This might seem somewhat counterintuitive, as economists often point to a tight Fed as a cause of recession. However, if we drill down into the recent periods when the Fed Funds rate was too high (’99-’00, ’06-’07), we see that each period was indeed followed by a market collapse.
Using the Taylor rule, we now have a better sense of when the equity markets are overpriced or underpriced. Any market-wide equity buying strategy can use the new Taylor rule as an additional confidence indicator.