Where are Interest Rates Headed?
The Federal Reserve’s aggressive lowering of short-term interest rates from 6½% to 1¾% in 2001—unprecedented in speed and magnitude—was the principal reason that year’s recession was the mildest ever. But three subsequent reductions in the federal funds rate put it at a mere 1% at this time last year. The appropriateness of these later rate cuts has been much debated but will never be resolved. What is clear, however, is the need to reverse course. Real GDP increased 5% over the past year, inflation doubled, and the jobless rate declined from 6.3% to 5.6%. This naturally raises a practical question: Where are interest rates headed?
Even those personally responsible for Federal Reserve policy can’t answer this question definitively. Nonetheless, we offer two useful guidelines providing approximate answers.
The first is a concept known as the “real” federal funds rate, which is simply the actual rate minus a measure of underlying inflation. Over the past year, for example, the core consumer price inflation (which excludes volatile food and energy items) has risen from a 1¼% pace to a 2½% pace. Since the federal funds rate held steady at 1%, the real federal funds rate fell from –¼% to –1½%.
Apart from its simplicity, the real federal funds rate has other appealing attributes. For example, computing its long-term average—at 1.9% over the past 45 years—provides a reasonable measure of “normal” since it transcends periods of economic recession and expansion. It also transcends periods of rising inflation (the 1960s and 1970s) and periods of falling inflation (the 1980s and 1990s). Moreover, the real federal funds rate tended to be below this average during the former period and above this average during the latter period, suggesting its influence over inflation.
The Taylor Rule—named after Treasury Undersecretary John Taylor, from his days as an academic—picks up where the real interest rate concept leaves off. Specifically, it stipulates that a normal level for the federal funds rate is a 2-point spread over the past year’s rate of inflation. It then adjusts this normal rate for two considerations: inflation and the business cycle.
If inflation is running higher than the Federal Reserve’s target, the normal federal funds rate is increased by half the difference, and visa-versa. So, if inflation is running at 3% and the Fed’s target is 2%, then half the difference, or ½%, is added to the normal federal funds rate.
The business cycle adjustment says if the economy is operating above its long-term potential, the normal interest rate should be increased, and visa-versa. More specifically, if the economy is operating 1% above its theoretical potential, the normal interest rate should be increased by half that amount, or ½%. Conversely, if the economy is operating below its potential by 1%, the normal interest rate should be reduced by ½%.
If inflation is precisely where the Fed wants it and the economy is operating precisely at its potential, then no adjustments are required and the federal funds rate should simply be 2 points over inflation.
Unfortunately, the Federal Reserve doesn’t tell us what its inflation target is, and the economy’s theoretic potential is an elusive concept that defies reliable measurement. But we expect 2005 to look like a normal year in all relevant respects. If the economy is fully employed and inflation is running between 2% and 2½%, which is also where the Fed wants it, then the federal funds rate should return to its normal spread over inflation, which puts it between 4% and 4½%.
While not guaranteed, the above analyses and conclusions are based upon currently available information which is believed to be reliable.
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