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Economist John Taylor: Interest rates should go to around 3%

Brian Cheung

Stanford economist John Taylor said Friday the benchmark interest rate should be closer to 3%, suggesting the economy has the capacity to absorb another two 25 basis point rate hikes.

Taylor, once considered for Federal Reserve chairman by the Trump administration, told Yahoo Finance on Friday that at the moment the central bank appears to be closely following the monetary policy rule that he engineered.

“I’ve always thought, given the best estimates, that the rate should go to around three. So they’ve kind of stopped for the time being, closer to about 2.5%,” Taylor said in an interview on the sidelines of a monetary policy conference at Stanford University. “We’ll see if that actually happens, so of course it depends on the circumstance — it depends on what happens to inflation, it depends on what happens to the economy.”

On Wednesday the Federal Open Market Committee elected to hold rates steady at its target range of 2.25% to 2.5% as policymakers acknowledged that inflation is “running below” its target.

Taylor added that while the economy has suffered from a “slower recovery,” he applauded the Fed’s decision to raise rates four times in 2018.

John Taylor headshot, Stanford Univerity Professor of Economics. Source: Associated Press

“We’ve actually had faster growth since the fed started to normalize,” Taylor said. “2017, 2018 have been an increase in growth.”

Taylor rule

The Taylor rule suggests that the central bank target interest rates based on an equation factoring in current and expected values for inflation and unemployment, in addition to an estimate of the economy’s long-run neutral interest rate.

The challenge is that policymakers do not have a precise way of measuring the economy’s long-run interest rate, also referred to as r*. But Fed officials have signaled that they see the current rate level at neutral.

At the conference, Fed Vice Chairman Richard Clarida said the federal funds rate is “now in the range of estimates” of its longer-run neutral level, adding that if you plug in those estimates into the Taylor rule, the suggested interest rate is “very close” to its current target range.

Taylor said he is encouraged by the Fed’s consideration to his policy rule, saying that Clarida, Fed Vice Chairman Randal Quarles, and New York Fed President John Williams are all proponents of evaluating the Taylor rule in policy decisions.

Proponents of the Taylor rule argue that rules-based monetary policy is the optimally transparent form of policy since market participants would know exactly how rate decisions are made.

The Fed has said policy rules ignore important information like financial and credit market conditions or indicators of consumer and business sentiment. However, the FOMC has acknowledged using the Taylor rule as “guidance” in its decision making.

“The Fed has moved in that direction,” Taylor said. “In the last couple of years, it started with Yellen; it’s been supported by Powell.”

Brian Cheung is a reporter covering the banking industry and the intersection of finance and policy for Yahoo Finance. You can follow him on Twitter @bcheungz.

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