Interest Rate Benchmarks

How does a central bank know when to raise interest rates? Benchmarks derived from simple algebraic formulas can be thought of as recommendations that a central bank can use to guide its policy choices – not to be followed mechanically, but as a guide to generally good policy. Benchmarks like simple Taylor rules make sense as a prescriptive guide because good monetary policy outcomes were realized when Fed policy tracked them fairly closely, whereas significant deviations have been associated with less successful periods. Following benchmarks also makes sense as a way to anchor the public’s expectations, strengthening the Fed’s credibility. Two representative Taylor rule estimates – including one that accounts for a potential recent decline in the natural rate of interest – suggest that the federal funds rate is currently quite far below benchmark recommendations. The current economic outlook suggests that our benchmark rates are likely to continue to rise. This fact, bolstered by historical experience, provides a strong case for raising interest rates sooner rather than later.