Targeting the Federal Funds Rate

Roughly every month and a half, the Federal Reserve's Open Market Committee meets in a dark cellar with a dark purpose - to sacrifice a goat and to read its entrails so that they might set the level of the Federal Funds Rate.

Or something like that. The truth is that there's precious little public knowledge about what exactly the Fed does when it sets the interest rate that it charges banks for overnight loans to support their operations.

Fortunately however, there's a whole platoon of Fed-watching economists and analysts who have created their own methods of reading the Fed's tea leaves to divine what the Fed will do. Today's new tool is based upon a method for estimating what level the Fed is ultimately targeting when it sets the Federal Funds Rate that was developed by Greg Mankiw, Harvard professor, former chairman of the President's Council of Economic Advisors, and experienced practioner of the dark, dismal science.

Mankiw's method for estimating the Federal Funds Rate was outlined in his May 2001 paper on U.S. Monetary Policy During the 1990s (available as a 96KB PDF document) and again in a recent blog entry.

To use the tool, you'll need two simple bits of data:

1. The current Consumer Price Index inflation rate (excluding food and energy) over the last 12 months.
2. The current Seasonally Adjusted Employment Rate.

And that's all - now you too can, in the words of Mankiw, "set interest rates like a pro!"

Economic Data
Input Data	Values
12-Month Percent Change in Consumer Prices, Less Food and Energy (%)
Seasonally Adjusted Unemployment Rate (%)

Estimated Level of Federal Funds Rate
Calculated Results	Values
Federal Funds Rate to Target (%)

Code created with assistance from Political Calculations

Using the tool's default data, which is current as of May/June 2006, the method estimates that the Fed should set the Federal Funds Rate to 5.42%. At the current level of 5.25%, this suggests that the Fed may be very close to its desired target rate for the current economic circumstances, with a good probability that the Fed's Open Market Committee will increase the rate once again by .25 points to 5.5%.

At least, that is, until current economic circumstances change again - then its back off to the basement with a frightened goat....