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January 2012
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The Fed may raise interest rate sooner than expected

Greg Mankiw explains:

I estimated the following simple formula for setting the federal funds rate:

Federal funds rate = 8.5 + 1.4 (Core inflation – Unemployment).

The parameters in this formula were chosen to offer the best fit for data from the 1990s.

Eddy Elfenbein has recently replotted this equation.  Here it is:

The interest rate recommended by the equation is the blue line, and the actual rate from the Fed is the red line.

Not surprisingly, the rule recommended a deeply negative federal funds rate during the recent severe recession.  Of course, that is impossible, which is why the Fed took various extraordinary steps to get the economy going.  But note that the rule is now moving back toward zero.  As Eddy points out, “At the current inflation rate, the unemployment rate needs to drop to 8.3% from the current 8.5% for the model to signal positive rates. We’re getting close.”

The only caveat is the estimation was done in 1990s.  It captured the Fed’s interest rate policy in 1990s, but may not be accurate for the current Fed, especially when the Fed chooses to deviate from the Taylor rule.


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