by TankHappy
The federal reserve is increasing rates to the recommendation of an economic thoery called Taylor’s Rule. While this rule isn’t always perfectly followed it does show whether to increase or decrease rates. It is a theory that observes output gaps and inflationary gaps in attempt to hit targets. Let me show you how it works and the current target rate according to this rule.
The formula: Federal Funds rate = r* + pi + 0.5 (pi-pi) + 0.5 ((100(y-y)/y*))
Definitions: r*= 2% why .5?= .5 is used to show which one the fed finds more important to target, inflation or output gaps. Other Central banks have different values. For example in Europe they focus more on Inflation so the values might be closer to .75 and .25. It all depends on what is more important. Historically speaking the FED has been found to keep these around .5 for both. This also might explain why other economists or organizations have different opinions based on how they define these values.
pi= 2.4% current inflation rate
pi*= 2% target inflation rate( according to the federal reserve’s reports we been targeting 2% for almost a decade)
Y= output GDP
Y*= potential output or GDP
Now I replace output with unemployment from the idea of Okun’s law, which is used to predict output changes based on changes in unemployment. It states for every 1% increase in unemployment it decreases output by 2% until we reach natural unemployment. Not to break out into another theory but the idea is not everyone should be employed and there is a natural level of unemployment level where output is actually decreased due to too much employment. Okun’s law is found using y-y/y= -2(u-u*).
Definitions: u= 4.1% (unemployment) u*= 4.6%(target or natural rate of unemployment. Not known but estimation)
So let’s write out the equation and solve with Okun’s law inserted.
Federal Funds Rate = 2% + 2.4% + .5(2.4%-2%) + .5(-2(4.1%-4.6%))
Target Federal Funds Rate: 5.1%
So the target based on Taylor’s Rule is 5.1%. Although we may not see this for a while this is roughly the target. The Federal Reserve wants to raise interest rates slowly out of fear of causing shocks to the economy and hurting the recovery. Random fact, Taylor was interviewed by Trump for the Fed Chairman position but was probably denied because he would raise interest rates at an even faster rate than we are currently seeing. You can use this equation to predict almost any change in interest rates. It is never perfect but it does a great job at predicating. I challenge you to go back in history and plug in past numbers and see how close they were to what the Fed actually set them to at that time. All the values used can be found at Fred.stlouisfed.org