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The Fed’s checklist - Rabobank

FXStreet (Guatemala) - Analysts at Rabobank note that the Fed’s first rate hike will be a major theme for the financial markets in 2015.

Key Quotes:

“Since the start of the hiking cycle will depend on the economic developments next year, we take a look at the Fed’s reaction function”.

“We start with the well-known Taylor rule, which expresses the policy rate as a function of the deviations of inflation and unemployment from their targets”.

“Although we point out the econometric flaws in the common way of estimating this monetary policy rule, we are able to preserve the economic reasoning behind the Taylor rule by rewriting it as an error correction mechanism, because the fed funds target rate and its long run equilibrium are cointegrated”.

“Our Taylor rule shows that the current levels of unemployment and inflation are pointing to the end of the near-zero interest rate policy”.

“However, we also argue that the Fed’s reaction function is more complicated than suggested by the Taylor rule. In practice the FOMC is looking at more variables than just inflation and unemployment”.

“The Fed’s checklist: besides inflation and unemployment, they are also looking at underemployment, wage growth, employment growth and the housing market”.

“Moreover, the Fed is looking for thresholds for each single variable, instead of simply adding up the gaps between variables and their targets as suggested by the Taylor rule”.

“Our framework for understanding the Fed is that they would like to ‘tick all the boxes’ before launching the hiking cycle. This framework applies to any economic recovery scenario: no matter whether the economy will improve faster or slower than currently expected. Once all the boxes are ticked, we should expect the Fed to hike”.

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