What is the Taylor Rule?

What is the Taylor Rule?

The Taylor rule is an algebraic formula proposed by John Taylor, a Stanford economist, in his 1993 paper “Discretion Versus Policy Rules in Practice.” He proposed this principle after an empirical study of the Federal Reserve’s monetary policy from 1987–1992. From his research, Taylor noted that the policy rate had closely tracked his proposed rule in the preceding five years. Highlighting the drawbacks of discretionary policy, Taylor presented this principle as a systematic guideline for monetary policy.

By applying an algebraic formula with two economic inputs — price level (inflation) and real GDP, the rule outlines a systematic, rule-based approach to set the Federal Reserve’s (FED’s) benchmark lending rate. Initially, Taylor acknowledged that it was challenging to implement a mechanical formula as a policy tool in a rapidly changing economy. However, he later advocated for stricter adherence to the rule. Taylor noted that prior discretionary policies led to boom-and-bust cycles, whereas a rules-based system would be a more effective monetary policy.

The Taylor rule links the Fed’s benchmark interest, the Fed funds rates, to inflation and economic growth. The Fed funds rate is the short-term lending rate that banks and the Fed use when lending to each other for short periods, usually overnight. By increasing or decreasing its target for the Fed funds rate, the Fed, through the Federal Oversight Market Committee (FOMC), maintains price stability and promotes maximum employment.

Taylor’s rule proposes that the Fed funds rate should be adjusted based on the divergence between the actual and target inflation rate and the output gap — the difference between real GDP growth and expected GDP. The output gap measures the difference between expected economic growth when labor and capital are fully employed and the actual economic growth. When there are no differences between actual and target inflation and real and expected GDP growth, the Taylor rule settles at its equilibrium rate of 2%.

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How to calculate the Taylor rule

Maintaining price stability and fostering maximum employment are the key mandates of the Fed. It implements this through various monetary policy tools. Setting the Fed funds rates is the primary policy tool, establishing a target for the overnight inter-bank lending rate. The Taylor rule, derived from a study of prior monetary policy, is a mathematical formula that calculates the appropriate interest rates based on changes in inflation and economic growth.

The Taylor formula is as follows:

r = p + 0.5y + 0.5(p – 2) + 2

Where:

r = nominal Fed funds rate

p = the rate of inflation

y = the percent deviation between current real GDP and target or trend GDP

The Federal funds rate, r, is the product’s formula and the overnight lending rate that banks use to lend funds to each other. It is the nominal rate before inflation.

The variable, p, denotes the price level in the economy, otherwise called inflation. Initially, Taylor used the GDP deflator as a measure of inflation. It is an index that shows the increase in all prices in an economy over a given period. This measure of inflation differs from the Consumer Price Index (CPI) because it considers capital goods inflation and imputed government spending. The GDP deflator also excludes imported consumer goods.

Y is the output gap. Usually, the Fed sets its GDP growth target at a level assuming maximum capital deployment and full employment. Real GDP might sometimes overshoot or undershoot and register a divergence from the expected long-term trend. The output gap is the difference between the expected and the actual GDP figure.

Finally, the coefficient for the divergence in inflation and the output gap is 0.5. Therefore, for each 1% increase in inflation or GDP growth, there should be a 0.5% increase in the Fed funds rate.

In designing the formula, Taylor made some assumptions. First, he assumed an inflation target of 2%. Thus, based on the formula, a 1% increase in inflation above the desired target of 2% leads to a 0.5 percent point increase in the policy rate. Also, the formula prescribes a 0.5 percent increase in the policy rate for each 1% divergence in economic growth. The rule also sets an equilibrium interest rate. When inflation is at the assumed target of 2%, and there is no output gap, meaning that real GDP growth is near the historical trend, there is a real equilibrium rate of 2% and a nominal rate of 4%.

Over the years, there have been several modifications to the Taylor rule. Some economists prefer measuring inflation using the core Personal Consumption Expenditures (PCE) rather than the GDP deflator. Core PCE excludes energy and food prices, which are more volatile; hence it’s viewed as a more accurate indicator of inflation. Other Taylor rule versions have emphasized the output gap by increasing its coefficient from 0.5 to a higher number. Some economists don’t mind higher volatility in inflation in support of increased ability to control the output gap.

In recent years, policymakers have cited the Taylor rule as a helpful guideline in setting the Fed funds rate. However, policymakers at the Fed have not strictly followed the Taylor rule. For instance, the Taylor rule prescribed a higher rate for three years before the 2007–2008 housing crisis. The Fed ignored the signal for higher rates by the rule and kept rates lower. Critics have explained that this is one of the factors that led to the housing market heating up and triggering the great financial crisis in 2008.

Criticism of the Taylor rule

Though the Taylor rule is effective as a general policy guideline, it has some flaws. One, it is limited by the zero-bound, which means it can recommend a negative fed funds rate, but this is not always possible as interest rates cannot go beyond zero. Critics also highlight that it doesn’t include other important economic variables such as the unemployment rate in its calculation. Omitting unemployment is a weakness since maximum employment is one of the statutory mandates that the Fed must fulfill.

Another criticism of the original Taylor rule is that it uses the GDP deflator to calculate inflation. Its use eliminates some consumer prices from inflation since the GDP deflator ignores imports of consumer goods. It also adds capital goods and imputed costs of government spending on items such as defense. Some policymakers have pointed out that a better measure of inflation would be the PCE deflator that mainly focuses on a basket of non-volatile consumer items.

Finally, economists have argued that a mechanical formula is unsuitable for setting the Fed funds rate. Policymakers such as Ben Bernanke, the former Federal Reserve chair, have highlighted its limitations in a complex and dynamic economic environment. For example, the rule omits other monetary instruments such as quantitative easing.

The Bottom Line

Generally, the Taylor rule has been a useful forecasting tool for the Fed’s interest rate. Since 1993, the Taylor rule has accurately tracked and aligned with where the Federal benchmark interest rate should be. There have been periods of departure, such as 2005–2007 and 2010–2015, but these have only emphasized its importance. Its proponents point out that when the Fed has deviated from the Taylor rule, the economy has failed to respond appropriately. For instance, the 2007 housing crisis and the sluggish economic recovery in the early 2010s.

The Taylor rule is a valuable predictive tool for setting the Fed fund rate targets. Despite its limitations, such as the zero-bound, it helps policymakers adjust interest rates to inflation and economic growth changes. Setting policy rates based on a formula that factors in price level and economic output is an effective way to implement monetary policy. Such a prescriptive and methodical approach eliminates the instability and visibility problems that can arise from adherence to a purely discretionary policy.

RELATED CATEGORIES: Monetary Policy