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The Fed Fund Interest Rates Setting Regime: The Taylor Rule,[1],[2],[3]

[4]

This section attempts to summarize how the U.S. Federal Reserve Board decides on a suitable level for the Fed Fund interest rates (the interest rate charged by banks to each other for overnight borrowing to balance their books, which is set by the Fed). The Fed Fund rate is one of the important tools used by the Fed to decide on interest rates, which set the policy of money supply in order to influence U.S. monetary and economic policy. It is important that RF bankers and scholars in RF law understand the foundations on which these decisions are made and the mechanical procedures followed. This information reveals that the Fed Fund rate set by the Federal Reserve is a tool by which the monetary authorities manage the money supply; it is different from the usury or interest prohibited by the injunctions of the RF Judeo-Christian-Islamic Law (Shari'aa).

Professor John Taylor of Stanford University in California formally introduced the Taylor Rule in 1994 to model the process by which the Federal Reserve System sets a suitable Fed Fund rate. He suggested that the two primary factors that drive the model are the gross domestic product[5] (GDP) gap and the inflation gap. This model was improved upon and new models were developed. It is discussed here to introduce the reader to this important monetary management approach.

Intuitively, these two factors have economic bases. This policy rule states that if the economy is growing beyond its potential, or if the inflation rate is greater than the Fed's assumed target of, say, 2 percent, the Fed will increase the Fed Funds. Professor Taylor argued that the Federal Reserve Board can be viewed as setting the target for the Federal Fund rate at a level that is close to, say, 2 to 2.5 percent, with a level corrector mechanism. He recommended that two correctors are added. These are:

1. An inflation corrector•, called the inflation gap. It equals current inflation rates minus the inflation rate targeted by the Fed.

2. An economic growth corrector, called the output gap (GDP corrector), which is equal to current GDP minus potential GDP.

He also suggested that a most likely scenario is that the impact of the correctors is equally weighted, at 50 percent each. Another scenario might call for a different weighting — such as, for example, the allocation of 70 percent for inflation and 30 percent for GDP, or vice versa. This will depend on the situation, the country involved, and the strategic options available to the central bankers. It is important to clarify further that the interest rate component of the equation is a mere rate or percentage; it is conceptually and materially different from the usury (price charged for using money) or interest (the price for renting money). In this context, this rate is in fact a percentage rate that influences the rate at which fiat — money — should be grown (by printing more) or shrunk (by selling government bonds at high rates to absorb the excess liquidity or by increasing the reserve requirements of the banks). The equation suggested can be written as follows:

Target Short-Term Fed Funds Interest Rate = Rate of Inflation as Measured by GDP Deflator + Equilibrium Real Interest Rate (defined approximately as prevailing interest rate minus inflation) + an Inflation Contribution + an Economic Growth Rate (Economic Output) Contribution

The definitions of the components of the Taylor formula are as follows:

Rate of inflation: As defined by a basket of products and services in the economy.

Equilibrium real interest rate: Interest rate charged by banks and financial institutions minus inflation rate (approximately).

The interest rate charged by banks and financial institutions to their customers is in fact the riba we are talking about; it is prohibited in the Judeo-Christian-Islamic value system because it conceptually represents paying a price for the use or rental of money. This rate, as we discussed in Chapter 3 and will discuss in more detail later, should be obtained using the mark-to-market rule, not the rental rate of money.

Inflation contribution•. A percentage of the inflation gap, defined as current inflation rate minus target inflation rate, as defined by policymakers. Taylor suggested that we give it a 50 percent weight. However, one can give it a different weight depending on monetary policy goals and strategies.

In the case of the U.S. Federal Reserve System, the policy targets mentioned earlier are discussed and agreed on in a special committee, the FOMC. The committee discusses the trade-off between the Fed's goal of price stability through achieving a low inflation rate and the need to maintain maximum economic growth and output, as well as the highest employment possible. To achieve low inflation, Fed Fund rates need to be raised. However, if the committee wanted the highest employment and economic output, they would adopt a policy that reduces the Fed Fund interest rate. The committee's most important challenge is to try to discover, project, and then decide the most suitable and optimum course of action regarding the Fed Fund rate. In addition, Taylor's equation shows that the Fed Fund interest rate decided by the Fed is needed to adjust the monetary policy in a fiat (paper) money regime, and is far different from the charging of interest prohibited by the RF law (the Judeo-Christian-Islamic Shari'aa), as discussed in Chapter 2. The Fed Fund rate is a percentage sign used to influence monetary policy and to decide how much money to print or withdraw from the system in a world run on fiat (paper) money. In the case of the Judeo-Christian-Islamic value system, there is a world of difference between the renting of real money (as discussed in the six commodity indexes in Chapter 3) and the Fed Fund rate as described clearly by the Taylor Rule.

  • [1] Richard A. Brealey and Steward C. Meyer, Principles of Corporate Finance, 6th ed. London: Irwin/McGraw-Hill, 2000), 49.
  • [2] R. Charles Moyer, James R. McGuigan, and William J. Kretlow, Con-temporary Financial Management (Mason, OH: South-Western Centgage Learning, 2008), 163.
  • [3] For a detailed outline of the many papers, books, and analyses on the Taylor Rule, please visit stanford.edu/ ~johntayl/PolRulLink.htm.
  • [4] Professor John Taylor, Stanford University. Please visit Professor Taylor's personal home page: stanford.edu/ ~johntayl/.
  • [5] GDP is a measurement of the national income and output for a given country. It is a measurement of the total value (in local currency or indollars) of all fi nal goods and services produced in that economy in a given year.
 
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