How to Calculate Federal Funds Rate

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Taylor Rule: Federal Funds Rate Calculator

Estimate the recommended target interest rate based on economic indicators.

(Actual GDP – Potential GDP) / Potential GDP

Recommended Federal Funds Rate

0.00%
Breakdown:
  • Inflation Gap contribution: 0%
  • Output Gap contribution: 0%
function calculateFedRate() { var pi = parseFloat(document.getElementById('currentInflation').value); var piStar = parseFloat(document.getElementById('targetInflation').value); var rStar = parseFloat(document.getElementById('neutralRate').value); var yGap = parseFloat(document.getElementById('outputGap').value); if (isNaN(pi) || isNaN(piStar) || isNaN(rStar) || isNaN(yGap)) { alert("Please enter valid numbers in all fields."); return; } // The Taylor Rule Formula: i = r* + pi + 0.5(pi – pi*) + 0.5(y – y*) // Where (y – y*) is the output gap. var inflationGap = pi – piStar; var infContribution = 0.5 * inflationGap; var outContribution = 0.5 * yGap; var recommendedRate = rStar + pi + infContribution + outContribution; document.getElementById('fedResult').innerHTML = recommendedRate.toFixed(2) + "%"; document.getElementById('infGapResult').innerHTML = "Inflation Gap contribution: " + infContribution.toFixed(2) + "%"; document.getElementById('outGapResult').innerHTML = "Output Gap contribution: " + outContribution.toFixed(2) + "%"; document.getElementById('fedResultContainer').style.display = "block"; }

Understanding the Federal Funds Rate Calculation

The Federal Funds Rate is the most influential interest rate in the global economy. It is the target interest rate set by the Federal Open Market Committee (FOMC) at which commercial banks borrow and lend their excess reserves to each other overnight.

What is the Taylor Rule?

While the Federal Reserve uses a wide array of data to set rates, economists often use the Taylor Rule to predict or evaluate what the rate should be. Proposed by economist John Taylor in 1993, this formula suggests how much the central bank should change the nominal interest rate in response to changes in inflation and economic output.

The Components of the Formula

  • Current Inflation Rate: The annual rate of price increases (usually measured by the PCE or CPI).
  • Target Inflation Rate: The Fed's ideal inflation level, historically anchored at 2.0%.
  • Neutral Real Interest Rate (r*): The "Goldilocks" rate where the economy is neither expanding nor contracting. Historically estimated around 2.0%, though this fluctuates.
  • Output Gap: The difference between the actual growth of the economy (GDP) and its maximum sustainable potential growth. A positive gap suggests an overheating economy, while a negative gap suggests slack.

How to Calculate it Manually

The standard Taylor Rule formula is expressed as:

Rate = Neutral Rate + Inflation + 0.5(Inflation Gap) + 0.5(Output Gap)

Practical Example

Imagine the following economic conditions:

  • Current Inflation: 4.0%
  • Target Inflation: 2.0%
  • Neutral Rate: 2.0%
  • Output Gap: 1.0%

Step 1: Calculate the Inflation Gap (4.0 – 2.0 = 2.0). Half of that is 1.0%.

Step 2: Calculate the Output Gap contribution. Half of 1.0% is 0.5%.

Step 3: Add it all up: 2.0 (Neutral) + 4.0 (Current Inflation) + 1.0 (Inf. Gap adj) + 0.5 (Output Gap adj) = 7.5%.

In this scenario, the Taylor Rule would suggest a Federal Funds Rate of 7.5% to cool down the economy and bring inflation back toward the target.

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