The Taylor rule is a quantitative guideline used by central banks to set short-term interest rates. It falls under the broader category of monetary policy and aims to stabilize the economy by responding to changes in inflation and economic output. Developed by economist John B. Taylor, this policy rule suggests a target for the nominal interest rate, such as the Federal Funds Rate in the United States, based on deviations of actual inflation from its target and actual Gross Domestic Product (GDP) from its potential. The Taylor rule is often discussed in the context of achieving price stability and full employment, which are common objectives for a central bank.
History and Origin
The Taylor rule was introduced by Stanford economist John B. Taylor in his 1993 paper, "Discretion Versus Policy Rules in Practice."15 Taylor observed that a relatively simple formula could effectively describe the actual behavior of the Federal Reserve's federal funds rate during a period of macroeconomic stability from 1987 to 1992.13, 14 His work provided a quantitative framework for understanding how a central bank might adjust interest rates in response to changing economic conditions, shifting the focus from purely discretionary policy to a more systematic, rules-based approach. The rule quickly gained attention in academic and policy circles for its simplicity and its ability to explain past monetary policy decisions.11, 12
Key Takeaways
- The Taylor rule is a formula that suggests a target short-term interest rate for a central bank.
- It proposes adjusting the policy rate in response to the inflation gap (actual inflation vs. target inflation) and the output gap (actual GDP vs. potential GDP).
- The rule implies that the nominal interest rate should rise more than one-for-one with an increase in inflation to ensure that the real interest rate increases, thereby cooling the economy.10
- It serves as a benchmark for evaluating monetary policy decisions and fostering transparency.
- While influential, the Taylor rule is not universally adopted as a strict guide, as central banks often incorporate other factors and exercise judgment.
Formula and Calculation
The original Taylor rule is expressed as:
Where:
- (i) = the target nominal interest rate (e.g., the federal funds rate)
- (r_n) = the assumed real interest rate that would prevail when the economy is at full employment and stable inflation (often set at 2% for the U.S.)9
- (\pi) = the current inflation rate (e.g., core Personal Consumption Expenditures (PCE) inflation)
- (\pi^*) = the central bank's target inflation rate (e.g., 2% for the Federal Reserve)
- (y - y^*) = the output gap, which is the percentage deviation of real Gross Domestic Product (GDP) from its potential or trend level. A positive gap indicates the economy is overheating, while a negative gap suggests slack.
- (\alpha) = the coefficient for the inflation gap, typically 0.5 (meaning the nominal rate increases by 1.5 percentage points for every 1 percentage point increase in inflation above target).
- (\beta) = the coefficient for the output gap, typically 0.5.
In the original formulation, if inflation is at target (2%) and the output gap is zero, the rule suggests a Federal Funds Rate of 4% (2% real rate + 2% inflation target).8
Interpreting the Taylor Rule
Interpreting the Taylor rule involves understanding its implied guidance for central bank actions. When actual inflation rises above the central bank's target, or when economic growth leads to a positive output gap (meaning output is above its sustainable potential), the Taylor rule suggests that the central bank should raise its policy interest rates. Conversely, if inflation falls below target or the economy experiences a negative output gap (indicating a recession or underutilization of resources), the rule prescribes lowering rates. This mechanism aims to counteract inflationary pressures or stimulate economic growth, guiding the economy back towards stability and the central bank's dual mandate of full employment and price stability.
Hypothetical Example
Consider a hypothetical economy where the central bank's target inflation rate is 2%, and the assumed equilibrium real interest rate is 2%.
Suppose current economic data shows:
- Current inflation ((\pi)) = 3%
- Output gap ((y - y^*)) = 1% (meaning GDP is 1% above its potential)
Using the standard Taylor rule with (\alpha = 0.5) and (\beta = 0.5):
In this scenario, the Taylor rule suggests a target nominal interest rate of 6%. This higher rate would aim to dampen inflationary pressures and cool down the overheating economy by making borrowing more expensive, thereby reducing aggregate demand. Conversely, if inflation were 1% and the output gap -2%, the rule would suggest a much lower rate to stimulate activity.
Practical Applications
The Taylor rule serves as a significant analytical tool in the field of monetary policy. Central banks and economists use it as a benchmark to assess whether current interest rates are consistent with macroeconomic conditions, particularly regarding inflation and economic growth. It offers a transparent framework for discussions about the stance of policy, helping to explain past central bank actions and project potential future moves. For instance, the Federal Reserve Bank of Atlanta provides a "Taylor Rule Utility" to allow users to generate federal funds rate prescriptions based on various inputs, illustrating its application in current economic analysis.7 Academic research frequently employs the Taylor rule to evaluate the effectiveness of historical monetary policy, particularly during periods like the Great Moderation, where central bank policy was seen as successful in maintaining low and stable inflation.6 The rule's continued relevance is highlighted in ongoing discussions about central bank frameworks, especially during periods of high inflation.5
Limitations and Criticisms
Despite its widespread influence, the Taylor rule faces several limitations and criticisms. One significant challenge lies in the measurement of key variables, particularly the output gap and the equilibrium real interest rate ((r_n)). These variables are unobservable and subject to significant estimation uncertainty, which can lead to different policy prescriptions depending on the chosen methodology.4 Critics also argue that the rule's simplified form may not adequately account for all relevant factors influencing monetary policy, such as financial stability considerations, exchange rate movements, or structural changes in the economy.
Furthermore, strictly adhering to the Taylor rule can be problematic in unusual economic environments, such as when interest rates approach the effective lower bound (often zero). In such scenarios, the rule might suggest negative nominal rates, which are difficult for central banks to implement directly through conventional tools.3 Some economists also contend that a mechanistic application of the rule can stifle the necessary judgment and flexibility central bankers require to respond to unforeseen events or unique economic shocks.2 For example, the International Monetary Fund (IMF) has discussed how central banking frameworks have evolved to address new challenges post-crisis, implicitly acknowledging the limitations of rigid rules.1
Taylor Rule vs. Federal Funds Rate
The Taylor rule is a prescriptive formula that suggests what the Federal Funds Rate should be, based on economic conditions, particularly inflation and the output gap. It acts as a guide or a benchmark for monetary policy.
The Federal Funds Rate, on the other hand, is the actual target interest rate set by the Federal Open Market Committee (FOMC) of the U.S. Federal Reserve. It is the real-world policy instrument that the central bank uses to influence the economy. While the Taylor rule has often tracked the historical behavior of the Federal Funds Rate and serves as a point of reference for policymakers, the FOMC does not mechanically follow the rule. Its decisions incorporate a broader range of economic data, forecasts, and qualitative judgment, sometimes leading to deviations from the rate prescribed by the Taylor rule.
FAQs
What is the primary purpose of the Taylor rule?
The primary purpose of the Taylor rule is to provide a systematic framework for central banks to set short-term interest rates in response to macroeconomic conditions, primarily deviations of inflation from its target and economic growth from its potential. It acts as a guide for monetary policy to achieve goals like price stability and full employment.
Is the Taylor rule a law that central banks must follow?
No, the Taylor rule is not a law or a strict mandate. It is a theoretical policy rule and an analytical tool. While central banks may consider its prescriptions as a benchmark, they typically maintain flexibility and exercise judgment, meaning their actual Federal Funds Rate decisions may deviate from the rule's suggestions.
How does the Taylor rule relate to inflation targeting?
The Taylor rule is highly compatible with inflation targeting. Its formula explicitly includes an "inflation gap" component, which measures the difference between current inflation and the central bank's desired inflation target. The rule suggests that the central bank should raise interest rates more aggressively when inflation exceeds its target, thereby reinforcing the central bank's commitment to achieving its price stability objective.
What are the main inputs into the Taylor rule?
The main inputs into the standard Taylor rule are the current inflation rate, the central bank's target inflation rate, the output gap (the difference between actual and potential GDP), and an assumed equilibrium real interest rate.