I think I saw something useful in a book called _Wall Street_.
But here's how I (and many of the Federal Reserve staff I sometimes hang out with) think about it.
Since 1980 you do a pretty good job of figuring out what the Federal Reserve will do if you write that they are following roughly the following rule for setting nominal interest rates on three-month Treasury bills:
1) Start at an interest rate of 5% per year.
2) Add 1.3 percentage points for each one percentage point of current annual inflation.
3) Subtract 0.5 percentage points for each percentage point of current unemployment.
This rule does not perfectly model Federal Reserve behavior. Interest rates were higher than this "Taylor rule" would have predicted in 1980, and remained higher throughout the 1980s: the Volcker-led Federal Reserve did not lower interest rates as fast as the rule would suggest as inflation fell (and unemployment remained relatively high) in the 1980s. Some Federal Reserve staff would say that the Volcker-led Open Market Committee was too cautious in that decade. In the early 1990s, the Greenspan-led Federal Reserve pushed interest rates below the values the rule would suggest in order to provide political cover and impetus for deficit reduction. But the rule does pretty well.
As of October 1999 the rule suggested 3-month Treasury bill rates of 5%--dead-on to what the Federal Reserve's then target was. During late 1998 and most of 1999 short-term interest rates had been below their Taylor-rule values because the Federal Reserve had eased in order to diminish the danger that the international financial crisis would deepen.
Since October 1999 the Federal Reserve has tightened substantially, and short-term interest rates are now 1.25% above their Taylor-rule values. Federal Reserve staff refuse to speculate on why the Open Market Committee has done this, but they say that some possible considerations include:
1) The fact that the faster productivity growth seen in recent years is likely to mean a higher rate of profit, and that there are theoretical reasons to think that the "equilibrium real interest rate" should increase with increases in the rate of profit. This would add about one percentage point to the appropriate short-term interest rate.
2) Working in the other direction, a more smoothly-functioning labor market in which a lower rate of unemployment is consistent with stable inflation--which is what we have seen in the past half decade--should lead one to lower one's target value for the interest rate: the Taylor rule raises the interest rate when unemployment falls not because they dislike low unemployment for its own sake but because they dislike the inflationary pressures that low unemployment generates. If the NAIRU has fallen by 2%, this would subtract about one percentage point from the appropriate short-term interest rate.
3) Because Federal Reserve actions affect the economy only with a long lag, good monetary policy depends not on what unemployment and inflation are but on what unemployment and inflation will be next year, and the speed of demand and production growth over the past four quarters lead at least some of the Federal Reserve's forecasting models to predict an inflation rate one percentage point higher and an unemployment rate of 3.5 percent by the middle of 2001. If you credit such forecasts, this would add about two percentage points to the appropriate short-term interest rates.
4) None of the econometric models are tracking or forecasting well. This suggests that policy should be made on the basis of what is happening, not on what faulty and poorly-tracking models predict. This consideration would wipe out consideration (3).
5) Last, there is the question of what is the appropriate balance of risks. If interest rates are too high, we have high unemployment, low production, and low incomes--a power country. If interest rates are too low we have accelerating inflation, and eventually a collapse of confidence in the Federal Reserve's commitment to control inflation. The Federal Reserve thinks the second risk is always the principal one to guard against. (Others disagree. In the words of one senior advisor: "the first is a lobotomy, the second is a head cold.") But if you believe that technological and structural change are uniquely strong in this epoch, and if you believe that policies to take advantage of such transformation pay high benefits, then you have to build an encompassing political coalition around riding this technological and structural transformation--and you can only do this in a high-pressure economy with a low unemployment rate. If one thought that the Federal Reserve's attitude toward risk was faulty, or if you thought that the benefits of a high-pressure economy *today* are uniquely great, then you would lower your view of the appropriate short-term interest rateby some amount.
I think that considerations (2) and (5) mean that the appropriate interest rate today is lower than the Taylor-rule rate, but I'm an optimist about the growth possibilities of high technology and globalization, and a realist about the difficulty of forming encompassing political coalitions for pro-growth policies in the absence of near-full employment.
Most Federal Reserve staffers I talk to think that considerations (1) and (3) are more powerful, and mean that the appropriate interest rate today is higher than the Taylor-rule rate. The Federal Open Market Committee seems to think so too.
Of course, all this leaves to one side the question of whether following the Taylor rule is a good policy for "normal" times. The Federal Reserve thinks that it is. The Taylor rule is in a sense a simple rule-of-thumb that codifies much of what Greenspan does, monetary policy under Greenspan has been highly successful, and it is hard to argue with such success...
Brad DeLong --
-- -- -- -- -- -- -- -- -- -- -- -- -- -- -- -- -- -- -- -- -- -- -- "Now 'in the long run' this [way of summarizing the quantity theory of money] is probably true.... But this long run is a misleading guide to current affairs. **In the long run** we are all dead. Economists set themselves too easy, too useless a task if in tempestuous seasons they can only tell us that when the storm is long past the ocean is flat again."
--J.M. Keynes -- -- -- -- -- -- -- -- -- -- -- -- -- -- -- -- -- -- -- -- -- -- -- J. Bradford De Long; Professor of Economics, U.C. Berkeley; Co-Editor, Journal of Economic Perspectives. Dept. of Economics, U.C. Berkeley, #3880 Berkeley, CA 94720-3880 (510) 643-4027; (925) 283-2709 phones (510) 642-6615; (925) 283-3897 faxes http://econ161.berkeley.edu/ <delong at econ.berkeley.edu>