What’s the Right Interest Rate for the Fed Anyway?

Standard models watched by economists at the Federal Reserve and elsewhere suggest that rates should now be lower

By Justin Lahart of The WSJ. Excerpt:

"So where should rates be? There has been a lot of focus recently on the long-term neutral rate—the just-right level of rates for when inflation is at the Fed’s 2% target, and the economy is growing at just the right pace to keep it there. When thinking about where rates ought to be, economists rely on a variety of models. Many of them are riffs on the Taylor rule, put forth by Stanford’s John Taylor in 1993. The complexity of these Taylor-style models varies, but in essence, they typically look at what inflation is doing versus where the central bank wants it, how fast the economy is growing versus an assumption of how fast it ought to grow without moving inflation off target, and spit out an answer.

The Federal Reserve Bank of Atlanta has set up a “Taylor Rule Utility” webpage that provides the outputs from three Taylor-style models, each of which shows that, under reasonable assumptions, the Fed’s target rate ought to have been lower in the fourth quarter, heading lower still this quarter. The Federal Reserve Bank of Cleveland does a similar exercise across seven models. Its most recent update, in December, showed that the median “right” level for rates as of the fourth quarter was 5.1%, falling to 4.8% in the current quarter and 3.9% by year-end."

I think the neutral rate is the rate that gives us just the right amount of total or aggregate demand (AD) to be at the full-employment unemployment rate or the natural rate of unemployment. Lower interest rates make it easier for people and businesses to borrow and spend.

One definition of the natural rate of unemployment is that it is the lowest rate of unemployment compatible with price stability (which the Fed defines as an annual inflation rate of 2% or less).

This graph shows that if we keep increasing AD (either by lowering interest rates, increasing the money supply or increasing government spending), Q (real GDP) will keep increasing which lowers the unemployment rate as firms need more workers. 

But the price level (CPI) will keep increasing more and more, meaning higher and higher inflation rates.

SRAS is short run aggregate supply. QF is the full-employment GDP (real GDP). When AD goes past AD2, we get significant price increases (for various reasons, we can't stay above QF for very long-see Fed Focuses on Inflation Sentiment).

Related posts:

Fed Focuses on Inflation Sentiment (Dec. 2021)

The Fed chairman says the relationship between inflation and unemployment is gone (2019)

Unemployment Isn’t What It Used to Be: The low rate doesn’t take account of low labor-force participation. Wages are a better indication of slack (2019)
 
The Phillips curve is alive and well (unless it's dead) (2019)

Is There A Neutral Interest Rate? If So, How Much Is it? (2018)

Is The Phillips Curve Dead In Japan? Maybe not (2018)

Is The Phillips Curve Not Holding Up Well Because The Service And Goods Sectors Are Behaving Differently? (2018)

Has the Fed Flattened the Phillips Curve? (2018)

Nobody knows what the natural rate of unemployment is today (2018)

More on the natural rate of unemployment (2018)

How Central Banks Differ In Their Methods Of Calculating Inflation (2018)

Fed Officials Disagree On Threat Of Inflation (from 2009)

Fed Chair Janet Yellen: "there remains considerable slack in the economy" (from 2014)

 

E-Commerce Might Help Solve the Mystery of Low Inflation (2018)

Fed officials disagree on how much inflation the current low unemployment rate might cause  (2018)

Fed Looks for Goldilocks Path as Jobless Rate Drops    (2018)

Is the Phillips curve affected by prices that are acyclical? (2019)

What is Full Employment?  (2020)

Jobs and Inflation: The Great Trade-Off, Demystified: The relationship between inflation and unemployment is real, but far from simple (2020)

Lower Inflation Likely Requires Higher Unemployment; How High Is the Question (2022)