Components of a Fed rate… Real rate & Inflation response

Below the previous post on Refining a NGDP target for a policy rate rule, there were comments by Reason regarding real growth of output and the effects of inflation. These are the two components of the Fed rate, which seeks to stabilize inflation and promote full-employment output growth.

I thought it would be helpful to post a graph that separates out those two components side by side. The data for the graph comes from my own equations for determining the short-term real rate and the inflation response in the Fed rate. (link) My equations determine the short-term real rate and the inflation response, and then add them together to prescribe a Fed rate.

First here is my equation plotted against the actual Fed rate. The blue line represents my equation to determine the Fed rate.

 ngdp inf tar 6

Now I will separate out the two components of my equation for the Fed rate.

ngdp inf tar 7

The blue line here shows the short-term real rate which reflects real output growth. You can see that it normally plateaued between 2% and 4% since the 1960’s. Normally real output growth was in the 3% range. But since the crisis, we see that real output growth is still below 2%. The economy is sick, unproductive and demand constrained.

The orange line represents the response to inflation so that nominal GDP would return to its price level target. The general pattern shows that the need to control inflation has been going lower. Now we have the reverse where there is a need to liberate inflation.

The complication now is that real output growth is suffering at the same time that inflation pressures are weak.