The purpose of this project is to observe policy interest rate rules in the wild. How do they work? How do they compare to the actual rate decision?
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The Federal Open Market Committee sets policies to impact this interest rate, the Fed Funds rate, based on the health of the economy and their outlook for the mid-term future. This rate is extremely important to the economy: it is the rate at which banks can lend to each other overnight. The chart shows the effective rate, which is the rate they achieved, since you cannot simply declare this rate.
The Federal Reserve has "dual mandate" where they use interest rates to target levels of inflation and levels of employment, while supporting growth.
Economist John Taylor proposed a recommendation for the Fed Funds rate in 1993. It responds to periods of high inflation with a higher interest rate. The formula has a few components:
Note: Learn more about Taylor and his rule here.
Let's examine how the Taylor Rate and the Fed Funds Rate compare over the last few decades. The green denotes when the Taylor Rate recommendation was over the actual Fed Funds rate.
Notice a few of the differences following a recession. The Taylor Rate is consistently higher, which shows the impact of discretionary monetary policy! We have accomodative polices keeping effective rate lower than the recommendation would allow. This shows how sensitive to inflation and blind to the future rules are.
How could new datasources impact our policy rate? The new line shows a new Taylor Rate calculation with inflation rates, not just a 2% steady inflation like we had before. The heigher rate recommendations come during periods of strong inflation, like the 1980s. The Billion Prices project at MIT is focused on large scale pricing data collection, which may provide an even more accurate estimate. Perhaps these datasources will be used by policy makers in the future.
But we are seeing the macro
picture of the economy, so subtle inflation changes aren't noticeable.
Or are they?
Let's play the FOMC.
enter an inflation rate and an economic outlook to make a forecast
I have included some projections for the rate for the next three years. Let's use the Taylor formula, Potential GDP projections, and your opinion of the economy to see what the rate would be for the next few years.