When Will the Fed Raise Rates?

According to the latest pronouncements from the Fed, the central bank doesn’t have plans to raise short-term interest rates for a few more years. But going by some economic models, a rate increase may not be that far away.

In January, I posted an interest rate model developed by Greg Mankiw. According to his model, this is where the Fed funds rate ought to be:

Federal funds rate = 8.5 + 1.4 (Core inflation – Unemployment)

For the last few years, the model has indicated negative rates and since the Fed can’t lower rates below 0%; that’s why we’ve had the QE policies.

Here’s how the Mankiw model looks compared with the Fed funds rate.

What’s more is that the surprising fall in the jobless rate we saw last week brings us even closer to a rate increase. We don’t yet have the September figure for core inflation but there’s a very good chance that it will finally signal positive interest rates for the Mankiw model.

The math works like this: With an unemployment rate of 7.8%, which we had in September, a year-over-year core rate of inflation of 1.8% would cause the model to signal interest rates of exactly 0%. Any core inflation rate greater than 1.8% would cause the model to show positive interest rates. The year-over-year core rate ending in August was 1.92%. The next consumer inflation report comes out on Tuesday.

Of course, this is just one model and it doesn’t mean that the Fed will follow it. I would think some members of the FOMC are troubled by the weak labor market participation rates, which is a fancy way of saying that lots of folks have stopped looking for a job. But still, the Mankiw model has fairly accurately shown what the Fed has done over the past several years.

In 2010, Paul Krugman crunched the numbers and came up with different coefficients for the model:

Federal funds rate = 9.0 + 1.8 (Core inflation – Unemployment)

Krugman’s model has interest rates lower than Mankiw’s. Still, the drop in the unemployment rate will push Krugman’s model to -1.6% (assuming 1.9% y-o-y core rate for September). That’s low but the Krugman model was signaling -9% two years ago.

I think it’s far too early to say that the Federal Reserve has “won” or that a rate increase will be coming soon. But it may be the case that a rate increase could happen before the Fed’s current timeline of 2015.

Posted by on October 11th, 2012 at 11:37 am


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