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Wednesday, September 1, 2010

The Taylor Rule Does Not Say Minus Six Percent

The Taylor rule says that the federal funds rate should equal 1.5 times the inflation rate plus .5 times the GDP gap plus 1. Currently the inflation rate is about 1.5 percent and the GDP gap is about -5 percent (using the average of the seven estimates of the gap provided in the recent update by Justin Weidner and John Williams).

So a little algebra gives a funds rate of 1.5X1.5 + .5X(-5) + 1 = .75 percent.

This number is nowhere near -6 percent, which is what you sometimes hear people say the Taylor rule implies. If you think that 1 percent is a better measure of inflation, then that would bring the interest rate down to 0 percent. If you use the largest of the seven gaps reported by Weidner and Williams ( – 8 percent) , then you get an interest rate of -.75 percent. Still nothing close to -6 percent.

How do people get such a large negative percent? As I discussed in this oped a year ago, it is probably because they change the Taylor rule, replacing variables or estimating coefficients with data during which the Fed has set interest rates too low for too long. This can give very misleading results.

Note that the numbers actually implied by the Taylor rule are close to the 0 to .25 percent range currently set by the FOMC. So if inflation begins to pick up or growth gets to be higher than potential GDP growth, then the interest rate should rise. Some , including my colleague Ron McKinnon and also Chuck Schwab, argue that the federal funds rate should be higher, perhaps 1 percent, because they are worried about the functioning of the money market or the low rates on saving. They are much closer to the Taylor rule than those who say -6 percent.