Should the Fed Funds Rate be 9% Today?

Apollo Chief Economist

In 1993, Stanford Professor John Taylor published a paper where he showed that the Fed funds rate has historically been equal to the sum of deviations from the Fed’s target for inflation and unemployment. For example, if inflation is above the Fed’s 2% target, the Fed funds rate will be higher. And if unemployment is above the Fed’s target, the Fed funds rate will be lower.

This relationship where the Fed funds rate can be predicted by inflation and unemployment is called the Taylor rule, and John Taylor’s contribution was to come up with the weights to inflation and unemployment that the Fed has used historically to give the best explanation of the actual Fed funds rate. The logic with using inflation and unemployment is that those two variables capture the Fed’s dual mandate of price stability and full employment.

The Fed has used this framework for decades for understanding what the Fed funds rate should be, and inserting the current level of inflation and unemployment into the Taylor rule shows that the Fed funds rate today should be 9%. Significantly above the current level of the Fed funds rate at 4.5%, see chart below.

The bottom line is that the Taylor rule framework normally used by the Fed for evaluating the stance of monetary policy is saying that the Fed is still significantly behind the curve.

Taylor rule says Fed funds rate today should be 9%
Source: Bloomberg, Apollo Chief Economist. Note:  (Taylor Rule (9.23) = Neutral real rate (2.00) + Core PCE (4.42) + [alpha(0.5)*{(inf (4.42) – target (2.00)}]+[beta(0.5)*{factor (2.0)} *{(NAIRU (5.0) – Unemployment (3.40)}]

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