Friday, June 30, 2006

What would Alan do?

There has been a lot of talk lately about whether the Fed will continue raising interest rates or pause for a while. I don't know the answer, but here is one way to think about it.

About five years ago, I wrote a paper on monetary policy in the 1990s. I estimated the following simple formula for setting the federal funds rate:

Federal funds rate = 8.5 + 1.4 (Core inflation - Unemployment).

Here "core inflation" is the CPI inflation rate over the previous 12 months excluding food and energy, and "unemployment" is the seasonally-adjusted unemployment rate. The parameters in this formula were chosen to offer the best fit for data from the 1990s.

Right now, core inflation is 2.4 percent, and unemployment is 4.6 percent. This formula says the federal funds rate should be set at 5.42 percent--just 17 basis point above the current target of 5.25 percent.

So we now seem to be very close to the rate that Alan Greenspan would have set under these conditions.