Wonky compass

27 April 2009 By Martin Hutchinson

The US central bank has calculated the optimal interest rate based on inflation and GDP. But its conclusion minus 5% doesn t add up. The socalled Taylor rule suggests a rate around 2%. The Fed is either underrating current inflation or overrating the output gap.

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An internal analysis prepared for the Federal Reserve policy meeting on March 1718, suggested based on its interpretation of the Taylor Rule for setting interest rates that the ideal theoretical federal funds rate would currently be around minus 5%.

The Taylor Rule for monetary policy, propounded by economist John B. Taylor in 1993, is to set the federal funds target at a rate of it given by:

it= pt+rt*+ap(ptpt*)+ay(ytyt*)

where pt is the rate of inflation as measured by the GDP deflator, pt* is the desired rate of inflation, rt* is the assumed equilibrium real interest rate, yt is the logarithm of current GDP yt* is the logarithm of potential output and ap and ay are constants, which Taylor recommended each be set at 0.5.

Currently consumer price inflation in the three months to March was 2.2%. Real GDP is around 3% below peak levels of 2008's second quarter (based on the consensus forecast of minus 5% annualised decline for 2009's first quarter), so the output gap can reasonably be estimated at 5%. Then with an assumed rt* of 2.5% and inflation target of 2% the federal funds target would be set at 2.3%.

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The Taylor Rule for monetary policy, propounded by economist John B. Taylor in 1993, is to set the federal funds target at a rate of it given by:

it= pt+rt*+ap(ptpt*)+ay(ytyt*)

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