CITIC Securities Co., Ltd.: Where is the end point of this round of Fed rate cuts from the perspective of the Taylor Rule?

According to the financial news app Zhitong Finance, CITIC Securities released a research report stating that the current level of US policy interest rates is too high when calculated using various Taylor rules, and the Federal Reserve still has a significant room for interest rate cuts next year. At the same time, in recent days, some Federal Reserve officials have hinted at a dovish stance, with some officials suggesting a further 50 basis point rate cut by the end of the year. They also mentioned that the policy interest rate level is too high, implying that there is still room for interest rate cuts next year. The bank believes that there is a high probability of another 50 basis point rate cut by the end of the year, and there is a possibility that the Federal Reserve may cut rates to below 4% next year.

Key points from CITIC Securities:

John Taylor proposed the Taylor Rule based on practical experience, using a formula to calculate the nominal federal funds rate as a guide for setting policy interest rates.

The Taylor Rule considers factors such as the inflation rate, deviation of inflation rate from the target, output gap (the difference between current output and long-term potential output), and inflation target when setting the federal funds rate. According to the Taylor Rule, the neutral (real) interest rate and inflation target are both set at 2% (fixed values), with the output gap used to assess the proximity of economic output to potential output. The Taylor Rule controls inflation through interest rate setting and provides accurate guidance for monetary policy formulation during stable periods. The nominal federal funds rate calculated by this formula can serve as a guide for setting the level of policy interest rates.

Bordo replaced the neutral rate with the expected real rate when the economy operates at a completely sustainable level, further developing the Taylor Rule to make the calculated interest rate level more reasonable.

Building on the 1993 version of the Taylor Rule, in 2022, Michael D. Bordo and Mickey D. Levy replaced the fixed neutral (real) interest rate with the Laubach-Williams (2003) actual interest rate in their calculations, while keeping other factors constant, resulting in a new estimate of the nominal federal funds rate. Due to different economic backgrounds at different times, the Bordo version of the Taylor Rule with a non-fixed real interest rate is considered more reasonable.

When considering various Taylor rule calculation methods, there is still significant room for interest rate cuts by the Federal Reserve next year.

In a speech in June 2023, Brad also discussed the results of the Taylor Rule under two assumptions. As of June 30, 2024, the policy interest rate range calculated by Brad using two methods is 2.48%-3.47%, with the current Taylor Rule policy interest rate calculated at 3.87% based on the implied neutral real interest rate level (0.9%) from the Fed's September meeting economic summary. Considering the possibility of further decline in US inflation in the third and fourth quarters and the risk of weakening US GDP, the interest rate level calculated by the Taylor Rule may decrease in the third and fourth quarters. At the same time, the Fed's long-term forecast for the federal funds rate is 2.9%. From multiple perspectives, the current policy interest rate level is considered too high, leading the bank to believe that there is a possibility of the Federal Reserve cutting rates to below 4% next year.

Recent dovish signals from Federal Reserve officials also suggest that the magnitude of this round of rate cuts may be significant. Recently, some Federal Reserve officials have indicated that they expect another 50bps rate cut within the year. They have not ruled out the possibility of a 50bps rate cut in the future. Furthermore, statements from Federal Reserve officials suggest that there is still room for rate cuts next year. Minneapolis Fed President Kashkari stated, "The policy rate of the Federal Reserve is expected to be 4.4% by the end of 2024 and 3.4% by the end of 2025," which is consistent with the median in the dot plot. On September 23, Atlanta Fed President Bostic believed that "the neutral rate is in the range of 3% to 3.25%, and a significant rate cut at the beginning of the easing cycle will help bring rates closer to the neutral level." Other Fed officials also believe that rates need to be significantly lowered. Chicago Fed President Evans stated on September 23, "More rate cuts may be needed in the next year, rates need to drop significantly," and he also believes that "rates are far above any perceived neutral level, the Fed still has a long way to go to bring rates closer to the neutral level, and there may be substantial rate cuts in the next 12 months." Therefore, the bank believes that there is a high probability of another 50bps rate cut within the year, and there is a possibility that the Fed will lower rates to below 4% next year.

Risk Factors: Unexpected changes in the U.S. economy, unexpected changes in U.S. inflation, unexpected changes in U.S. fiscal and other policies, unexpected geopolitical risks, etc