Monday, February 8, 2010

Did the Fed's Departure from the Taylor Rule Get Us in Trouble?

At the close of each of its Open Market Committee Meetings, held roughly every six weeks, the Fed announces its target for the federal funds rate, the rate of interest that banks charge each other for overnight loans of reserves. Note that the Fed doesn't force banks to charge that rate. What the Fed does is either speed up or slow down the rate of money growth using open market operations--buying or selling bonds on the bond market--thereby manipulating the federal funds rate in the desired direction. If the Fed wants the federal funds rate to rise, it slows the rate of money growth by selling bonds to banks; if it wants the rate to fall, it buys bonds from banks, thereby giving banks new reserves that they are free to lend.

Even though the Fed makes its interest rate decisions on a discretionary basis, for years the interest rate decisions of the Fed's Open Market Committee have mimicked the Taylor Rule, an invention of John B. Taylor of Stanford. The Taylor Rule says that the Fed could save itself a lot of time in meetings by setting the federal funds rate target using the following formula:

FFR = 2 + INF + 0.5(INF - 2) + 0.5GAP.

That is the Taylor Rule would set the federal funds rate (FFR) at two percent, plus the current inflation rate (INF), plus one half of the difference between the inflation rate and a target inflation rate of two percent, plus one half of the difference between current output and potential output (GAP).

Until recently the decisions of the Fed have tracked the Taylor Rule with amazing accuracy, leading some to wonder whether the Fed was -- whether intentionally or not -- following Taylor's formula. Yet in recent months the federal funds rate suggested by the Taylor Rule and the actual targets set by the Open Market Committee have diverged. This new segment from NewsHour takes a closer look (direct link).

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