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posted on 17 February 2017

Navigating By The Stars: The Natural Rate As Economic Forecasting Tool

from the Dallas Fed

-- this post authored by Evan F. Koenig and Alan Armen

Fed policymakers must assess the stance of monetary policy each time they decide whether the target federal funds rate should be changed. Several different benchmark, or “natural," interest rates have been suggested for this purpose. The gap between the target funds rate and the natural rate should, in principle, help forecast real economic activity and inflation.

ederal Reserve policymakers adjust the overnight interbank lending rate - the federal funds rate - in an effort to satisfy the Fed’s mandate to promote full employment and price stability. So it is important that they understand how the funds rate affects unemployment and inflation. One approach is to compare the level of the real (inflation-adjusted) funds rate to a “natural," “neutral" or “equilibrium" rate of interest. This reference interest rate is often called “r star" and is labeled r*.

A real funds rate above r* indicates F Navigating by the Stars: The Natural Rate as Economic Forecasting Tool by Evan F. Koenig and Alan Armen that monetary policy is restrictive, tending to drive the unemployment rate up and inflation down. A real funds rate below r* indicates that policy is accommodative, tending to drive the unemployment rate down and inflation up.

We examine three alternative empirical estimates of r* to see which is most useful for assessing the Federal Reserve’s policy stance. The measure that seems to perform best is a simple combination of a longterm interest rate and growth in household net worth. It suggests that recent policy has been accommodative, which means that the unemployment rate is likely to fall in coming quarters and inflation is likely to rise.

What Is r*?

In most macroeconomic models, there is a negative relationship - called the IS curve - between the real interest rate and the short-run level of output.1 In these models, r* is the real interest rate that is consistent with the economy operating at the full-employment level of output, y*.

[click on image below to continue reading]

Source: documents/research/ eclett/2017/el1702.pdf

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