A New Framework for Estimating the Optimal Policy Interest Rate

Executive Summary

A primary tool of monetary policy is the federal funds rate (FFR), which is the rate at which banks lend reserves to each other and functions as a key benchmark interest rate. The Federal Open Market Committee (FOMC), which is made up of Federal Reserve governors and District Bank presidents, sets a target range for the FFR based on policy goals. A higher FFR pushes up interest rates in the economy and therefore makes it more expensive to borrow, slowing down the economy.

On the other hand, reducing the FFR makes it cheaper to borrow money, prompting consumers and businesses to spend more and boost the economy. Determining the appropriate FFR to achieve policy goals is no easy task, as it relies on uncertain judgements about the current state of the economy and future prospects. In this report, we review common methods for estimating the appropriate target policy interest rate (we call this “r-optimal”) and propose a new estimation framework. Our framework estimates r-optimal based on the probability of expansion/recession and inflationary/deflationary pressure, unlike traditional Taylor-type policy rules that calculate an optimal policy rate based on deviations of inflation from policymakers’ objective and output from its “natural” or potential level. There are three major advantages of our methodology. First, it is forward-looking. Second, it does not use potential output as an explanatory variable, which is very difficult to estimate in real time. 1 Finally, our methodology applies time-varying weights to inputs, which allows us to take into account the changing nature of risks in an evolving economy.

Traditional Methods: Taylor Rule and Modifications

One of the most widely known methods for guiding central bank interest rate policy is the Taylor rule, which was outlined by John B. Taylor in 1993.2 According to the Taylor rule, the appropriate federal funds rate should be determined as a function of inflation and the output gap (i.e., the difference between actual output and potential output in the economy). The output gap is commonly measured using deviations of unemployment from its natural rate. If inflation is higher than the Fed’s target and/or when employment exceeds full employment, the FOMC should raise interest rates. Conversely, the FOMC should cut interest rates in periods of below-target inflation and high unemployment.

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