Monday, August 07, 2006

US rates

People usually have the Taylor rule as


i = (i* + π*) + ά1(π – π*) + ά2(y – y*)


with i* as the neutral real rate of interest (say 2%), π* as the inflation target (say 2%) and the brackets as the deviation of inflation from target and the deviation of the rate of growth from its potential.


Then much depends upon the ά parameters. Estimates for the Greenspan Fed show ά1 at 0.54 while ά2 was 0.99. For Volcker they were about 0.5 and 1.5.



Therefore, if we take inflation at 2.8% (PCE seems to come between 2.5% and 3.5% depending on how you measure it, so this is fairly conservative) and growth as 3.0% compared to a potential of 2.5%, we have 4% neutral nominal, plus another 0.5 for inflation and something for the output gap (say another 0.75%) would be 5.25%. Of course it depends on the assumption about potential growth. Many people would say that it is more than 2.5% and it depends on what people think the growth rate is at present. It could also be argued that the central bank needs to be more assertive in pushing down on inflation when there is a new Chairman gaining credibility and when oil prices are rising sharply.


The big weakness of the Taylor rule is that it does not deal well with the current situation. What if the output gap turns negative again but inflation remains high? In theory, many argue that ά1 should be more than 1 to ensure that the real rate rises to reduce inflation expectations.

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