April 28 (Bloomberg) -- A huge spread has developed in estimates of where the Fed is likely to stop once it begins to raise its 1 percent target for overnight rates.

Analysts and policy makers mention figures ranging from 2.5 percent to at least 5.5 percent or 6 percent, with vastly different implications for the economy depending on who might be closer to the mark. Moreover, the analysis behind the estimates varies significantly.

This debate over what constitutes a ``neutral'' federal funds rate, the level of the overnight lending rate that would be neither stimulating nor restraining economic activity, implicitly assumes the Fed won't need to go further to cool off an overheated economy, as it did in 1994.

Robert T. Parry, the retiring president of the San Francisco Federal Reserve Bank, is one of the few Fed officials who has been willing to offer his own estimate for the equilibrium funds rate.

``Based on the core personal consumption price index, the historical equilibrium real funds rate averaged 2.67 percent from 1966 first quarter to 2003 fourth quarter,'' Parry said in an e-mail response to a question.

The Ranges

``Since the growth of productivity is running considerably higher than the average for that period, I assumed that a reasonable range for the equilibrium real rate would be 2.5 percent to 3.5 percent. I also assumed a reasonable estimate for inflation expectations would be a core PCE inflation rate of 1 percent to 2 percent.

``Therefore, the range for the nominal natural rate would be between 3.5 percent (2.5 percent real and 1 percent inflation) and 5.5 percent (3.5 percent real and 2 percent inflation),'' Parry said.

Parry, who won't attend next week's Federal Open Market Committee meeting, added, ``I do not know when the rate will rise or how high it will go!''

The arithmetic of Mickey Levy of Banc of America Securities is very similar to Parry's.

``The natural rate would be the level of the funds rate that would generate aggregate demand that would be consistent with economic growth in line with its potential path, about 3.75 percent or 4 percent, and not change the rate of inflation,'' Levy said in an interview.

``I would say the real funds rate that would do that is around 2.5 percent to 3 percent, though maybe I would put a bigger range on it. One thing is sure, the neutral funds rate is a lot higher than 1 percent.''

`Unobservable'

The problem for the Fed, Levy said, it that the neutral rate ``is unobservable'' and it isn't constant. In theory, the rate should be higher when productivity growth is stronger because that means potential economic growth is higher, he explained.

What the Fed will do, he predicted, is begin tightening and as it does, officials will watch the economy's response and ``learn more about what that neutral rate is.''

On Monday Bob Ried of Ried, Thunberg & Co. weighed in with a figure lower than Parry's or Levy's.

``Once initiated, we expect that the funds rate will be moved persistently upward to around 3 percent to 3.5 percent equilibrium or neutral level,'' Ried told his clients. How fast the Fed moves the rate up will ``depend upon inflation and capacity utilization,'' he added.

Greenspan Should Tell

Paul McCulley, an irreverent economist who helps manage about $100 billion for Pacific Investment Management Co., wants Federal Reserve Chairman Alan Greenspan to tell him what the chairman believes would be a neutral funds rate. Fat chance.

McCulley laid out his view of the level of the neutral funds rate Monday night in New York in a speech to the Money Marketeers of NYU. He first explained it in his monthly newsletter last August.

His conclusion is that the real neutral funds rate is only about 50 basis points, far lower than anyone else's estimate. Some Fed officials find his argument intriguing.

McCulley said the actual real overnight rate for the period 1953-2001 was 1.4 percent. For the first half of that period, the average was only 0.5 percent.

``The average for the whole period was pulled up by the 2.5 percent average for 1979-2001. And for the 1979-2001 period, the Fed was explicitly holding the actual real short rate above its equilibrium level'' in its drive to reduce inflation, he said in the August newsletter.

Money and Rate of Return

In his analysis, McCulley argues that money -- as opposed to private sector capital investments -- shouldn't earn a real rate of return because it carries no risk. Instead, owners of money should receive only enough return to offset the taxes due on their income earned on the money and inflation.

``I don't buy that the `neutral' fed funds rate should be 4 percent if unemployment is at 5 percent and inflation is at 2 percent,'' he said. ``I think the `neutral' nominal fed funds should be 1 percent plus 0.2 percent (a high-side estimate for the economy-wide marginal income tax rate) times the Fed's 2 percent inflation target: 2.4 percent.''

McCulley said the Fed's exit from an extended period in which the Fed appropriately has held the funds rate well below its equilibrium level would ``be prudently lubricated'' if the Fed told the world its definition of the equilibrium real short- term interest rate.

Of course, that's not going to happen.

To contact the writer of this column: John M. Berry in Washington at jberry5@bloomberg.net.

Last Updated: April 28, 2004 00:02 EDT