RateWatch #418 – Where Should the Fed Funds Rate Be?

July 31, 2004 by Dick Lepre

What's Happening

The headline data - 2nd Q GDP - is weaker than expected at +3.0%. There are some footnotes: 1st Q GDP was revised upward from +3.9% to +4.5% making the +3.0% a tad less painful. Some of the dip in GDP growth was due to higher oil prices which persist. Relative geopolotical stability will bring oil prices back down. The Personal Consumption Expenditures Index, which is important to the Federal Reserve, rose 1.8 percent (annualized) in the 2nd Q. This is within tolerance. The GDP Deflator (another inflation measurement) was +3.2% which is above
expectation and above what the Fed wants.

The picture is indeed interesting:  we have slower economic growth, a valid excuse/explanation in the form of higher oil prices, and a Fed Chairman who talks "soft patch".

The bottom line is that 4.5% economic growth is great, 3.0% is just tolerable.  While there is nothing here suggesting what direction rates will be moved in by this data, there are two facts: 
1) low rates will allow for greater economic growth and
2) rates are "unnaturally" low and the Fed funds rate needs to get back above 3.0%. The Fed will continue to slowly raise rates.

In this week of a political convention folks also need to begin to recognize that politicians do not create jobs. Jobs are created by employers and employees with the help of the banking and equity systems under the guidance of the Federal Reserve.

Taylor's Rule

With the Fed funds rate so low and the Fed clearly on a path to hiking it would serve well to look what is generally believed to be a model of where the Fed funds rate should be - Taylor's rule.

Taylor's Rule is named for Dr. John B. Taylor a professor of economics at Stanford.  The Taylor rule is an attempt to formalize how the Fed moves the overnight rate in response to the measurement of two key things 1) inflation and 2) GDP growth.  Recall that the assignment given to the Fed is: Keep the economy growing at a moderate pace while keeping inflation low.  A scholarly presentation  of this is available in Acrobat format at

A somewhat more readable version is at


The Taylor rule is best regarded as a scientific explanation attempting to quantify the behavior of
the Fed by postulating a mathematical equation of the Fed's "reaction function". That is, if one analyzes the data: interest rates, inflation and GDP can one determine a rule that describes the Fed's behavior.

The specific and simple rule is based on the following
r = the equilibrium real fed funds rate (the "natural" rate that is consistent with full-employment)
I = the average inflation rate for the past 4 quarters
(note here that inflation is not CPI but the GDP deflator)
I* = the target inflation rate
y = the output gap (100*(real GDP - potential GDP)/potential GDP)

The equation is Fed Funds Rate = r + I +0.5(I-I*) +0.5y

If, for example, the target inflation rate was 2% and inflation (as measured by GDP deflator is 3%) then the Fed funds rate should be 2 + 3 + 0.5(3-2) = 5.5%.

In addition, if there is an output gap i.e. a difference between real GDP growth and "potential" GDP growth (a somewhat elusive concept) rates must be adjusted accordingly.  If GDP growth exceeds "potential" then rates must be increased.

In practice there are several major considerations. The Fed would like to react to the data slowly by adjusting the overnight rate slowly. The goal is the goal legislated for our monetary policy - stable prices and full employment. 

Some Complications

The global economy may have made Taylor's rule less relevant than it once was.  Markets are now influenced by global output gaps and global unemployment.  While businesspeople are working to integrate the world's economies others are resisting.  We have folks protesting at G8 and WTO meetings.  Politicians in the U.S. make the pitch of protecting jobs at home when, in fact, they have near zero ability to do so.