How High Should Interest Rates Be Right Now?

We hear a lot today about how the Fed is “behind the curve” and is allowing inflation to get out of control, but how can we actually quantify this? Just how far “behind the curve” is the Fed right now?

It’s difficult to say because ultimately the Fed’s decisions on interest rates are subjective and not based on any sort of formula–at least not any publicized formula that makes changes in interest rates predictable.

The closest thing we have to any sort of equation to tell us “what the interest rate should be” is the Taylor Rule, a formula created by economist John Taylor in the early 1990s.

The formula is as follows:

It basically takes into account the rate of inflation and the GDP growth rate and tells you what the Fed Funds Rate should be. The Fed does not religiously follow the Taylor Rule to set interest rates, but it does take its suggestions into account.

The important thing here is that the Taylor Rule is the closest thing we have to an “ideal” interest rate based on both GDP growth and current inflation rates. It provides us a rule of thumb that we can look at to see how far “behind the curve” the Fed truly is.

The Atlanta Fed’s website has a tool that calculates the Taylor Rate and plots it on a chart (blue) against the actual Fed Funds rate (purple).

What we can see is that the actual Fed Funds rate has been fairly close to what the Taylor Rule says it should be over the past 30-35 years, but it has not followed at a 1:1 ratio.

There was a pretty sizable gap in the early 2000s, when the Fed kept interest rates lower for a lot longer than the Taylor Rule indicated they should have.

But the biggest gap between the actual Fed Funds rate and the Taylor Rule’s prescription has never been higher than it is today. The Taylor Rule says the Fed Funds rate should be over 8%, and it’s at 0%.

In my recent posts, I have said that based on what I can tell from history, the Fed needs to raise interest rates to higher than the level of inflation in order to get inflation under control. That’s what it did during the early 1980s when inflation was red hot and surpassed 10% a year–interest rates went up as high as 20%.

The Taylor Rule, while it isn’t the be-all end-all, confirms as much, and is in my view validation of the assertion that the Fed is behind the curve–and significantly so.

Interest rates should be over 8% right now, but they’re at 0%.

This is the biggest gap between the actual Fed Funds rate and the Taylor Rule prescription on record. The last time the Fed was behind the curve significantly was the early 2000s, the overly-loose monetary policy of that era led to a devastating financial crisis.

The Fed needs to act and act swiftly.

I don’t think investors fully appreciate just how far behind the curve the Fed is right now.

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