Brad DeLong's Semi-Daily Journal (2004)

If you assume that the underlying productivity trend was 3.0% prior to 1975 and since 1995 and was 2.5% between to calculate the "neutral value" for fed funds by adding productivity and the 12 month change in the PCE deflator you get results very similiar to that from a Taylor rule calculation.

The rule now says fed funds should be at 5.5%.
The results show that in most of the 1990s actual fed funds was very close to where the "neutral rate" implied that should have been. In 1992-93 funds were significantly below
the neutral rate and in 1997-98 funds were modestly above the neutral rate. The neutral rate says funds should never have fallen below 4% -- a Taylor rule analysis implies they should have never fallen below 2.5% and now should be 4% versus 5.5% the neutral rate now calls for.

The other two big gaps when fed funds fell significantly below the "neutral rate" were in the recessions and early recoveries of 1970 & 1974.

One area where our knowledge is very poor is what monetary policy leads to inflation and
what is the interaction between monetary policy and other variables that leads to inflation and disinflation. If you use a Taylor rule or the "neutral rate" rule analysis you find that in the 1990s fed funds were roughly where the rule implied that should have been. But from
1960 to 1980 funds were also roughly where the rules implied they should have been. Under both rules funds were significantly above the implied rate in the 1980s. Clearly, in the 1980s funds above the level implied by the rules was associated with disinfation. But from 1960 to 1980 funds rougly at the levels the rules called for was associated with rising inflation. So following the same rule in the 1970s and the 1990s generated inflation in the first period and disinflation in the second era.

The first question in my mind in trying to explain the difference is lags. Was the disinflation of the 1990s largely a lagged response to the tight money policy under Volcker in the 1980s? If that is correct, it implies we may now be on the verge of an inflationary period as a lagged reaction to expansionary policy under Greenspan in the 1990s.

I do not have a clear answer, but I think it is a question we should be asking.

I have always wondered if rules like the ones Spencer describes include the estimated responses that other market players make, given that they have knowledge both of the terms of the rules, and real-time knowledge of the facts giving rise to exercise of the rules. Do these rules have an iterative, or feedback, component?

Masaccio -- I make my living advising portfolio managers on these type of things and you would be amazed at how few of them pay any attention to this type of analysis that has an outstanding record of leading the stock market. So the idea that there is a feed back rule that needs to be considered is hard to accept.

Let me give an example. I started my business in 1987 and was making many, many marketing presentations all through 1987. My leading indicators turned sharply negative months before the crash and my work said the market was the most overvalued it had been in the post WW II era. My discipline was clearly sending a very
strong message that a major bear market was ahead of us. No I did not expect it to happen in one day.

In New York most managers I gave this message to
argued strongly that it was different this time
and that I was wrong. In Boston most managers said I was probably right, but there were not going to do anything about it. In Chicago many managers agreed and said they were acting accordingly.

The typical portfolio manager really is a closet indexer and will not go against the consensus.
The risk-reward balance makes them this way. If they lose money doing what everyone else does they will probably keep their clients. But if they go out on a limb and lose money they will almost certainly lose their clients even if they are right. The consensus is formed by Wall Street analysis and they are paid to be bullish.
Their job is to give managers reasons to buy stocks, not to be right. Merrill Lynch, and other brokerage firms have a well deserved reputation for firing bearish analysts. All you have to do is watch CNBC to see this.

I agree with spencer. I use an entirely different approach but short term interest rates should be a minimum of 4% now. The fact that it's under that by 275 basis points is a direct contibutor to the real estate, venture capital, and hedge funds that are forming and have been documented at the NYT and Economist (links via my site).

If I didn't think it would kill the economy I would suggest what spencer suggests: 5-6% interest rates.

In addition, the failure to raise the Fed Funds rate to at least 4% has caused a shift in investment and speculation in China. Their credit restrictions are driving down nominal GDP but the always large off-the-books and backroom economy is still booming and it's going to go bust. As long as they've still got their currency pegged to ours they can't raise interest rates until we do to cool their economy down in real terms by tightening real credit. In addition all the "hot money" dollars streaming in trying to push up the Chinese currency on a speculative push is also heating things up beyond their saftey limit.

Greenspan may be engaging in an obscure show down with the Asian banking syndicates but the nation can't afford that right now. Of course if he did raise short term interest rates to what spencer and me suggested, that would probably something like triple debt service to nearly a trillion dollars a year from currently ~ 300 billion. That would cause a massive government spending contraction. But failing to do otherwise could create an even bigger market crisis of a "perfect storm" even bigger than the LTCM failure with an entire expanded hedge fund industry stepping in to play the role of the mighty fallen.

Any way you slice it we're in real trouble. If we had kept better interest rate discipline earlier like Europe we'd be in a better position now. The only question now is how bad it gets.

This is why I can not be a Fed FOMC man- I can't suspend my peasant common sense and stomach these insanely low rates- of course as a consumer they are great- but then I will be dead when it comes time to pay the money back- or I will wish I was dead;-} Productivity is a huge red herring for inflation- and inflate we do.

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