The Federal Reserve (Fed) uses econometric models extensively to conduct monetary policy. There are at least three types of models the central bank uses: (1) a large econometric model involving hundreds of equations, (2) the neutral rate and (3) the Taylor’s rule. What do they say about the current level of the interest rate? Is it too high or too low?
Large Econometric Model: These models help the Fed analyze complex economic relationships, forecast future economic conditions, and evaluate the potential impacts of monetary policy decisions. Econometric models allow the Fed to forecast economic conditions such as GDP growth, inflation, and unemployment. By analyzing historical data, these models can predict how changes in monetary policy might influence the economy. This is crucial for making informed decisions on setting interest rates and other policy measures, especially because monetary policy works with variable lags. For example, the Fed can estimate the effects of lowering or raising the federal funds rate on inflation and unemployment. This helps in understanding potential outcomes and risks associated with different interest rate paths.
The Federal Reserve does not release its model simulation results. However, Chairman Powell has stated that the current monetary policy is “restrictive” indicating that the interest rate needs to be cut lest it causes an economic downturn.
Neutral Rate of Interest: The neutral rate of interest, also known as the natural equilibrium, or R-star (r*), is the real interest rate (excluding inflation) consistent with the economy operating at full employment and stable inflation. In other words, the real neutral rate is the interest rate which neither helps nor hurts economic growth and inflation. Econometric models are used to estimate the real neutral rate, which is not directly observable. The real neutral rate varies over time due to changes in economic factors such as productivity growth and demographics.
The Federal Reserve compares the current interest rate (5.25 to 5.50%) with the estimated neutral rate (including inflation) to determine the stance of monetary policy (accommodative, neutral, or restrictive). If the actual rate is below the neutral rate, policy is considered accommodative, which can stimulate economic activity. Conversely, rates above the neutral rate can slow down the economy. Today, the neutral rate is estimated to be somewhere around 2.5 percent, which is much lower than the current level of the interest rate pointing to a few interest rate cuts.
Taylor's Rule: Taylor's Rule is a guideline for setting interest rates based on economic conditions, specifically inflation and the output gap (the difference between actual and potential economic output). Formulated by economist John Taylor, it suggests how central banks should adjust interest rates in response to changes in inflation and economic activity to achieve their inflation target and potential output. This simple model incorporates the current interest rate, the neutral real interest rate, target inflation rate, real GDP growth and the potential GDP. While not followed mechanically, it provides a systematic approach to policy-making that considers both inflation and economic performance.
What does the Taylor’s Rule say about the current interest rate? The Federal Reserve Bank of Atlanta publishes three different versions of the rule. The model says that the target rate should be somewhere between 3.9% to 4.7%, which is much lower than the current target rate of 5.25 to 5.5%.
In summary, econometric models, including estimates of the neutral rate and frameworks like Taylor's Rule, are essential tools for the Federal Reserve in conducting monetary policy. They help the Fed to make informed decisions aimed at achieving its dual mandate of maximum employment and price stability. They all point to significant cuts in the interest rate.