Monetary Policy

# Taylor rule

## What is Taylor’s rule?

The Taylor Rule (sometimes called the Taylor Rule or Taylor Principle) is an econometric model that describes the relationship between the Federal Reserve’s operating goals and inflation and GDP growth. The Taylor rule is interpreted both as a way of predicting the Federal Reserve’s monetary policy and as a fixed-rule policy that guides monetary policy in response to changes in economic conditions. The rule contains a formula linking the Fed’s operating target for short-term interest rates to two factors: the deviation between actual inflation and ideal inflation, and the deviation between real GDP growth and ideal GDP growth.

### key takeaways

• Taylor’s rule is a formula that can be used to predict or guide how a central bank should change interest rates in response to changes in the economy.
• The Taylor Rule recommends that the Fed raise interest rates when inflation or GDP growth is higher than expected.
• Critics argue that Taylor’s principle cannot explain sudden economic upheavals.

## Understanding Taylor’s Rules

In economics, Taylor’s rule is essentially a predictive model for determining what interest rates should be in order to move the economy toward stable prices and full employment. The Taylor Rule recommends that the Fed raise interest rates when inflation is high or employment exceeds full employment. Conversely, when inflation and employment are low, Taylor’s rule implies that interest rates should be lowered.

The Taylor Rule was invented and published in 1992-1993 by Stanford economist John Taylor, who outlined it in his seminal 1993 study, “Discretion and Policy Rules in Practice.” Taylor continued to refine the rule and revised the formula in 1999.

## Taylor’s rule formula

Taylor’s equation is as follows:

r = p + 0.5y + 0.5(p – 2) + 2

Where:

• r = nominal federal funds rate
• p = inflation rate
• y = percent deviation between current real GDP and the long-term linear trend of GDP

In a nutshell, this equation says that the Fed will measure the difference between actual inflation and the Fed’s desired inflation rate (assumed to be 2%) and the observed real GDP vs. Calculated by Taylor, from about 1984 to 1992, the growth rate was 2.2%). That means the Fed will raise its target federal funds rate when inflation is above 2% or real GDP growth is above 2.2%, and lower its target rate when either is below their respective targets.

The purpose of this equation is to study potential interest rate targets; however, such a task would not be possible without accounting for inflation. In order to compare inflation and non-inflation rates, an economy’s overall spectrum must be viewed in terms of prices. Changes to this formula are usually made based on the most important factors determined by the central bank.

## Other considerations

For many, the jury is not supporting Taylor’s rule because it has several shortcomings, the most serious of which is that it fails to account for sudden shocks or shifts in the economy, such as stock or housing market crashes. In his research and initial formulation of the rules, Taylor acknowledges this, noting that in the face of such shocks, strict adherence to policy rules is not always appropriate. Another disadvantage of Taylor’s rule is that it may provide ambiguous advice if inflation and GDP growth are moving in opposite directions.

During periods of stagnant growth and high inflation, such as stagflation, Taylor’s rule provides little guidance for policymakers because the terms of the equation tend to cancel each other out. While several issues with the rule remain unresolved, many central banks view the Taylor rule as a favorable practice, and some studies suggest that using a similar rule may improve economic performance.

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