The Natural Rate of Interest/Taylor Rate

Central banks often want to follow two contrary targets: low inflation and low unemployment. In order to achieve both criteria they look for a formula that can incorporate both of them. This is the idea behind the “Taylor Rate”.

 Natural interest rate according to Taylor/Greenspan 

“In practice, of course, the two problems of unemployment and inflation are competing with one another for the attention of Federal Reserve’s policymaking committee. The Federal Open Market Committee (FOMC) has to strike a balance between lowering interest rates and raising interest rates. It would actually lower or raise the federal funds target rate if one problem is judged to be more serious or more pressing than the other. Over time, the FOMC’s efforts to fight inflation and fight unemployment gives rise to a sequence of changes in the federal funds rate.

The actual pattern of federal funds rate during the early Greenspan years (1987–1993) is described by a simple equation introduced by John B. Taylor (1993) of Stanford University:

r = p + 0.5 q + 0.5 ( p – 2 ) + 2

where r is the targeted federal funds rate, p is the inflation rate over the previous year, and q is the percentage deviation of actual output from full-employment output. Taylor himself writes the equation using income (y) instead of output (q), but he defines y in terms of real GDP. In effect, yis a measure of q. The simple equation could be written in a still simpler form:

r = 1.5 p + 0.5 q + 1

but the original rendering has more intuitive appeal. It suggests that the implicit goal of the Federal Reserve is “full employment” and “2 percent inflation.” Note that if q = 0 (i.e., no deviation from full employment) and p = 2 percent, then r would be 4 percent. That is, the targeted federal funds rate would be 2 percentage points above the (2 percent) inflation rate. The two coefficients of 0.5 give equal weighting to the problems of unemployment and inflation generally. In particular instances, of course, one of those problems may be more severe than the other — as would be indicated by the actual values of p and q. Thus, the targeted federal funds rate r is low with a high and negative q; it is high with a high p.

The discretion needed for the Federal Reserve to fight the good fight (against unemployment and inflation) stands in contrast to the adoption of a Monetary Rule as advocated by Milton Friedman. According to this rule, the Federal Reserve should increase the money supply year-in and year-out at a slow and steady rate that approximates the economy’s long-run growth rate of 2 or 3 percent.”

source

In our calculations for the Swiss Taylor rate, we use the natural rate of interest (sometimes also “Neutral”) according a Taylor and Greenspan. For its calculations we use the CPI over the corresponding and the preceding quarter and the unemployment rate of the same quarter as basis. Swiss full employment is for us at 2.8%, in 2008 there was over-employment.

George Dorgan
George Dorgan (penname) predicted the end of the EUR/CHF peg at the CFA Society and at many occasions on SeekingAlpha.com and on this blog. Several Swiss and international financial advisors support the site. These firms aim to deliver independent advice from the often misleading mainstream of banks and asset managers. George is FinTech entrepreneur, financial author and alternative economist. He speak seven languages fluently.
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