Can Household Risk-Aversion Measures Predict Fed Policy?

The so-called Taylor Rule in monetary policy suggests how the Federal Reserve should adjust interest rates based on movements in inflation and economic output.  Although the Fed has never explicitly followed such a rule, it described fairly well the path of interest rate policy under much of Alan Greenspan’s tenure as chairman.

Our own primitive “Geo-Graphics Rule” suggests that from 2000 to 2008 the Fed also tended to move rates in line with household (and nonprofit) risk aversion, which we define in terms of the ratio of their currency, deposits (mostly insured), and money market fund holdings to their total financial assets.  The predictive power of our “rule” was strong (with an R² of 0.77, meaning that it was able to predict 77% of the variation in the Fed Funds rate), even measured against Taylor (with an R² of 0.69 from 1987 to 1999, and 0.51 from 1987 to 2006, using John Taylor’s 1993 formula and CBO measures of potential GDP).

Household risk aversion soared as the financial crisis unfurled in 2008 and 2009, at which point our Geo-Graphics Rule suggests that the Fed Funds rate should have gone deeply negative.  In its stead, the Fed cut the rate to near-zero and engaged in “quantitative easing” (QE) to expand its balance sheet, mimicking the effect of negative interest rates.

Household risk aversion has bounced around since 2011, as has the Fed Funds rate predicted by our rule.  Actual Fed policy has generally been more accommodative than predicted over the past 18 months.  Today’s Fed Funds rate should, on past experience, be near 1%.

What does the Geo-Graphics Rule say about prospects for more QE going forward?  The Fed’s Flow of Funds data are released with a three month lag, so we won’t know where today’s risk-aversion measure stands until late September.  Given recent market volatility, it is likely back on the rise.  A modest one percentage point move upward would suggest another round of QE before the end of the year.

We thank our former colleague Neil Bouhan for his contribution to this post.

Taylor: Discretion Versus Policy Rules in Practice

Chart Book: Economic Recovery

Video: Conducting Monetary Policy at the Zero Bound

Kansas City Fed: Taylor Rule Deviations and Financial Imbalances