Mankiw Model Signals Fed Is Closer To Hiking Rates

Last Friday's U.S. jobs report pushed the unemployment rate down to 7.5 percent. If the current trajectory in the unemployment rate continues and core inflation picks up, the Federal Reserve may hike rates in the first half of 2014.

Mankiw Fed Funds Rate Model jumps to 52-month high
Based on the new unemployment figures of 7.5 percent and 1.9 percent annual rate in core inflation, the Mankiw Fed Funds Rate Model jumped to a 52-month high (see chart below). The model is currently standing at 66 basis points, leading to a negative spread of 41 basis points between the Fed Funds Rate and the rate the model suggests, indicating the Fed's historical behavior.

As we alluded to back in October 2012, the Fed is cautious and is likely to let the "spread" widen to minus 200 basis points before hiking rates, mirroring its behaviour from 2003. Whether that tells us it has learned something or not is for others to judge.

In October 2012, we experimented with the numbers to get to a minus 200 basis points spread. Our findings were that a 2.5 percent annual change in core inflation and an unemployment rate at around 7.0 percent would be enough to produce the necessary spread prompting action from the Fed. Given the current data, this suggests that core inflation has to rise by an additional 60 basis points on an annual basis, and the unemployment rate has to decline by an additional 50 basis points.

Taking into account a rising or at least stabilising participation rate as more and more people are employed, these changes in core inflation and the unemployment rate are definitely in sight by late this year, depending of course on a mild impact on consumer spending from the sequestration. Overall, the odds for the Fed to hike rates in the first half of 2014 have gone down.