Mankiw's Taylor Rule

Harvard economics professor Greg Mankiw came up with a simple equation in a 2001 paper entitled "U.S. Monetary Policy During the 1990's" as a proxy for the Fed's Taylor Rule. The equation was originally developed as a best fit for monetary policy during the 1990's. However, even today it seems to be doing a fine job of predicting the direction of interest rate movements. Here is the equation:

Federal funds rate = 8.5 + 1.4 (Core inflation - Unemployment)

Courtesy of Crossing Wall Street: "In July, the unemployment rate was 4.647% and core CPI was 2.210%. That translates to a Fed Funds rate of 5.088%, which is below where the Fed is now. Here’s a look at how the Mankiw Rate compares with the real Fed Funds rate over the past few years":

I think the fact that the Mankiw rate was above the real fed funds rate from 2001-2006 is telling. Some have argued that the housing bubble was largely the result of the fed funds rate being held too low too long by Greenspan. Greenspan's defense was that a "risk management" approach was necessary to avoid the risks of a deflation.

Interestingly, at the Federal Reserve Bank of St. Louis' annual symposium at Jackson Hole Harvard professor and NBER chief Martin Feldstein defends Greenspan's risk management approach and is currently arguing for a full 1% rate cut in coming months.

On the other hand Stanford economist John Taylor (author of the Taylor rule) argues that "a higher funds path would have avoided much of the housing boom … The reversal of the boom and thereby the resulting market turmoil would not have been as sharp.”

As is evident in the debate between Feldstein, Taylor and others, the jury on Greenspan is still out. As the economy unwinds after years of easy credit Greenspan's policies in the early part of the decade will continually be under the microscope.