Art Cashin On Why You Shouldn’t Rule Out “QE 2.5”

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In his daily letter, UBS floor guy Art Cashin looks the prospect of more Fed easing (of some sort) after QE2 officially ends this summer.

QE2 To End? Don’t Rule Out QE 2.5 – The dollar rally is being attributed in no small part to the anticipated end of QE2.

The thesis is that when QE2 ends, the Fed will remain a buyer of U.S. Treasuries but on a somewhat smaller scale. That, it is thought, may allow yields on Treasuries to snug up a bit and that might help the dollar.

The QE2 “enders” cite the speeches by several Fedheads, fretting aloud about latent inflation (although dissenting votes have been quite rare).

But, there’s a silent vote that seems to suggest QE2 may need to be extended. It’s not a Fed President or Governor. It’s the Taylor Rule.

As you may recall, John B. Taylor, in 1993 wrote a paper in which he outlined what became known as the Taylor Rule. The “rule” sets out a monetary policy that suggests how the Fed should adjust rates to meet changing conditions in inflation, GDP and the like.

On Monday, Jim Brown, the multi-decade veteran at Premium Investor, wrote the following:

The Taylor Rule is an economic formula that the Fed uses to model the appropriate Fed funds target rate. Today the Taylor rule says the Fed funds rate should be a -1.65%. A negative interest rate is obviously not practical so this suggests the Fed may need to take additional action of some sort to further stimulate the economy. Whether that means QE3 or some other form of stimulus is unknown.

We haven’t had a chance to double check Jim’s calculation of the Taylor formula, but he has a long history of being very thorough. We will carefully parse the language of Chairman Bernanke, Vice Chair Yellen and New York Fed President Dudley over the next several weeks. This could get interesting.

For what it’s worth, others have suggested similar things. Bill Gross, for example, believes that Fed buying may end, but that uber-dovish “language” will form the basis of further easing.

As for the rule itself, here’s Wikipedia:

According to Taylor’s original version of the rule, the nominal interest rate should respond to divergences of actual inflation rates from target inflation rates and of actual Gross Domestic Product (GDP) from potential GDP:


In this equation,


is the target short-term nominal interest rate (e.g. the federal funds rate in the US),


is the rate of inflation as measured by the GDP deflator,


is the desired rate of inflation,


is the assumed equilibrium real interest rate,


is the logarithm of real GDP, and


is the logarithm of potential output, as determined by a linear trend.

In this equation, both aπ and ay should be positive (as a rough rule of thumb, Taylor’s 1993 paper proposed setting aπ = ay = 0.5).[4] That is, the rule “recommends” a relatively high interest rate (a “tight” monetary policy) when inflation is above its target or when output is above its full-employment level, in order to reduce inflationary pressure. It recommends a relatively low interest rate (“easy” monetary policy) in the opposite situation, to stimulate output. Sometimes monetary policy goals may conflict, as in the case of stagflation, when inflation is above its target while output is below full employment. In such a situation, a Taylor rule specifies the relative weights given to reducing inflation versus increasing output.