“Vanguard’s model uses 25 inputs in four broad categories—inflation, labor market, financial conditions, and global commodities—to produce probabilities for the direction of Fed moves in the near future,” said Boyu (Daniel) Wu, a Vanguard senior investment strategist.
The model incorporates data from the present, six months ago, and 12 months ago—all to simulate the type of decision-making made by the Federal Open Market Committee that looks at trends to set policy rates, Wu said. “Backtested over a five-year period, the model has been 80% accurate in predicting Fed moves and 77% more accurate than the traditional Taylor Rule, which uses inflation and GDP data.”
“The Vanguard model is unique in using both market and macroeconomic fundamentals as inputs,” Sathe said. “For Fed moves well into the future, where we don’t have current data as inputs, the model uses our economic team’s in-house views as inputs.”
As with any method of prognostication, there are no guarantees.
“If economic conditions become far worse than expected, the Fed may become dovish and start cutting rates sooner than expected, but we see that as unlikely,” Sathe said.
In the meantime, the model provides a more accurate assessment of probabilities, allowing active investors to potentially position themselves better and passive investors to have more conviction to stay the course.