How to Calculate Federal Funds Target Rate

Federal Funds Target Rate Calculator (Taylor Rule)

Standard central bank target is usually 2.0%.

The "R-star" rate where the economy is at full employment.

Percentage difference between Actual GDP and Potential GDP.

Calculated Target Rate: 0%

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How to Calculate the Federal Funds Target Rate

The Federal Funds Target Rate is the interest rate at which commercial banks borrow and lend their excess reserves to each other overnight. It is the primary tool used by the Federal Reserve to manage monetary policy. While the FOMC (Federal Open Market Committee) decides this rate based on a variety of economic indicators, economists often use the Taylor Rule to estimate what the target rate should be.

The Taylor Rule Formula

The standard Taylor Rule formula used in this calculator is:

FFR = r* + π + 0.5(π – π*) + 0.5(y – y*)

• FFR: Federal Funds Rate (nominal)
• r*: Neutral Real Interest Rate (The rate when the economy is in equilibrium)
• π: Current Inflation Rate
• π*: Target Inflation Rate (Usually 2%)
• y – y*: Output Gap (The difference between actual GDP and potential GDP)

Key Variables Explained

Inflation Gap: This is the difference between current inflation and the target inflation. If inflation is higher than the target, the formula suggests a higher interest rate to cool the economy.

Output Gap: This measures economic slack. A positive output gap means the economy is producing above its long-term potential (inflationary), while a negative gap suggests the economy is underperforming (recessionary).

Practical Example

Imagine the following economic conditions:

• Current Inflation: 4.0%
• Target Inflation: 2.0%
• Neutral Rate (r*): 2.0%
• Output Gap: 1.0%

Using the Taylor Rule:

FFR = 2.0 + 4.0 + 0.5(4.0 – 2.0) + 0.5(1.0)
FFR = 2.0 + 4.0 + 1.0 + 0.5 = 7.5%

In this scenario, the Taylor Rule suggests the Federal Reserve should set a target rate of 7.5% to combat the high inflation and positive output gap.

function calculateFedRate() { var currentInflation = parseFloat(document.getElementById('currentInflation').value); var targetInflation = parseFloat(document.getElementById('targetInflation').value); var neutralRate = parseFloat(document.getElementById('neutralRate').value); var outputGap = parseFloat(document.getElementById('outputGap').value); var resultArea = document.getElementById('resultArea'); var finalRateSpan = document.getElementById('finalRate'); var interpretation = document.getElementById('interpretation'); if (isNaN(currentInflation) || isNaN(targetInflation) || isNaN(neutralRate) || isNaN(outputGap)) { alert("Please enter valid numerical values for all fields."); return; } // Taylor Rule Formula: FFR = r* + pi + 0.5(pi – pi_target) + 0.5(output_gap) var inflationGap = currentInflation – targetInflation; var suggestedRate = neutralRate + currentInflation + (0.5 * inflationGap) + (0.5 * outputGap); finalRateSpan.innerText = suggestedRate.toFixed(2); resultArea.style.display = 'block'; var feedback = ""; if (suggestedRate > 5) { feedback = "This high target rate suggests a restrictive monetary policy is needed to curb significant inflation or over-expansion."; } else if (suggestedRate < 2) { feedback = "This low target rate suggests an accommodative policy is needed to stimulate economic growth or counteract deflationary pressures."; } else { feedback = "This rate suggests a relatively neutral or balanced monetary stance based on current economic data."; } interpretation.innerText = feedback; }