Above the noise: Mankiw model jumps to 45-month high on core CPI

With Fed's recent commitment to "QE Infinity" or QE as long as stable inflation is not in jeopardy and unemployment remains an issue, many investors believe this low level rate environment is here to stay for a long time due structural issues in the US economy. It might be, but on the other hand the Mankiw model for estimating the Fed Funds Rate has climbed to the highest level in 45 months (see image below).

(Year dates mark end-of-year)

The model is specified as Fed Funds Rate = 8.5 + 1.4 x (core CPI YoY - unemployment rate)

Given that core CPI YoY is currently printing 2.0 percent versus the average rate of 2.8 percent since 1985, the Fed is not near to taking the foot off the gas pedal in terms of QE. Unless the unemployment rate was to plummet.

So when is it likely for the Fed to begin entering the exit phase of QE?

The histogram below shows the difference between Fed Funds Target Rate and the Mankiw Model's rate estimate on every change in the Fed Funds Target Rate since 1985. There have been 97 of those changes. The histogram clearly shows that the distribution is tilted towards negative values. This skew can be explained by Alan Greenspan's aggressive moves following the dot-com bubble, when the Target Rate was lowered way more aggressively than what the Mankiw Model would suggest or anticipate. In the following boom years 2004-2006 the Target Rate was also tightened to slowing. The negative values indicate that the Target Rate is below where it estimated should be given unemployment rate and core CPI YoY.

We are in the environment where we are waiting for the Fed to normalise interest rates again. Given the Fed wants to be absolutely sure that the US economy has "escape velocity", as Pimco likes to put it, they will keep the Target Rate way below what is justified.

Therefore the negative values are of most interest to us. The mean and standard deviation among the negative values are -110 and 82 basis points respectively, with the minimum value being minus 272 basis points. The Fed is likely to begin raising the Target Rate when the spread is in the -27 to -193 basis points territory. Given these times are unprecedented, the probability is clearly skewed to the downside (that is closer to -193 in spread). Let us say that the Fed wants to blow an asset bubble again but has learned from its slowness in 2004-06 and aggressiveness in 2000-01. Minus 200 basis points could be very well be the inflection point for the Fed.

What numbers are we looking at to get a negative 200 basis points spread? Given the current spread is minus 13 basis points, we have some meters to run.  If we assume core CPI YoY goes to 2.5 percent and the unemployment rate gradually drops to 7.0 percent, then the Mankiw provides an estimated Target Rate of 220 basis points, versus the current Target Rate of 25 basis points. producing a negative spread of 195 basis points. At this point it does not seem unlikely that the Fed would begin hiking rates again. Given the current trajectory in the labour market, late 2013 or early 2014 could be the time where we get very close to the inflection point for rate hikes or at least talk about it.