You will often read in the news comments like the following.

Carl Tannenbaum said, “I think chances are evenly split between a cut and a hike right now it looks like inflation is coming down – but core inflation is still stubbornly above the Fed’s 2% target.

Why 2%, why not 3%, why not 1.12345%? After all 2% is some number somebody thought would be a good number. Well, the 2% number is based on a central bank strategy.

For starters, the central bank when controlling the economy have the following tools at their disposal:

  • Change interest rates.
  • Buy or sell government bonds from commercial banks.
  • Increase or decrease commercial bank reserve requirements.

All of these tools are used to control the equation

PQ = MV

where

P = price of goods

Q = quantity of goods

M = money supply

V = velocity of money

The tools and equation are applied using a strategy. For example one strategy that could be used to determine the health of the economy is to focus solely on the money supply. This approach was used in 1980’s.

Another approach involves the Taylor Rule. The Taylor rule is an equation that involves GDP growth rate, inflation rate and a fund rate. All of these factors are put together with some desired growth and inflation rates and voila you have a target fed rate. In the case of the Fed it means keeping inflation at 2%, and short term interest rates at 4%. If inflation runs above 2% then the way to stabilize the economy is to increase the interest rate.

Though here is the kicker and what I think is keeping Bernake awake at night, rising inflation and dropping growth. This is what many would call stagflation. The Taylor rule is constructed in such a way that it can be used even when you have stagflation. Following is a Taylor rule with specific assumptions made.

funds rate(t) = GDP price inflation(t) + 2.0 + 0.5 * (GDP price inflation(t) – 2.0) + 0.5 * (output gap(t))

The terms GDP price inflation is the deviation of the inflation from the ideal, and output gap is the deviation of the real GDP from the potential real GDP. By assuming a target interest rate of 4%, and an inflation of 2% the Fed is assuming a specific real growth rate.

I don’t want to bore you with numbers, but I want to point out something interesting in the equation. Let’s say that growth is going down, then the fund rate would go down. And if inflation goes up then the fund rate goes up. But what if we have stagflation? According to the equation it means you do nothing or maybe push interest rates up or down. So here is the question, if you use the Taylor rule and do nothing is that the right approach to stagflation?

I am not saying I understand the economy better than Mr Taylor. But what makes me skeptical is that the Taylor rule was invented in 1993 (at least what I can find). I am not doubting Mr Taylor, but as a friend told me, “if you have five economists and ask them a question you will get eight answers.”

So why did I point out the Taylor rule? Let’s say that the Fed does follow the rule, and what if you could correlate the equation to Fed decisions. Well, then you could predict using probability on whether the Fed will increase or drop rates. I suppose you could use the equation to scalp the market, no?