As usual, investors are pondering Federal Reserve Chairman Alan Greenspan's recent congressional testimony to get hints about future changes in interest rates. This speculation intensified last week with the announcements that the growth of gross domestic product had slowed but that wage inflation had picked up. Greenspan's opaque style suggests that the Fed's setting of rates is a mystery beyond the comprehension of mortal observers. But in fact, much of the variation in the federal funds rate--the interbank interest rate that the Fed controls closely--can be explained as Fed responses to two factors: inflation and aggregate economic activity.
The movement of the federal funds rate to these kinds of economic variables is often referred to as a Taylor rule, in honor of John B. Taylor, the Stanford University economics professor who enunciated the idea six years ago. Researchers have made numerous studies of the rule, partly as descriptions of actual monetary policy and partly as analyses of desirable policy. Using a variant of the Taylor rule, I recently found that the funds rate during the Greenspan era so far--August, 1987, to July, 1999--can be explained by three factors: Rates respond positively to inflation (changes in the GDP deflator), positively to real GDP relative to its trend, and negatively to the unemployment rate.
