The Taylor Rule, also known as Taylor’s rule or the Taylor principle, represents an equation connecting the Federal Reserve’s benchmark interest rate to both inflation and economic growth levels. It was introduced by Stanford economist John Taylor as a guideline for monetary policy, advocating for a fixed-rule policy to govern the Fed’s actions. This concept has gained traction among policymakers aiming to limit the Federal Reserve’s discretion.
Key Takeaways
- The Taylor Rule links the Federal Reserve’s policy rate to inflation and economic growth.
- Developed by John Taylor in 1993, it posits an equilibrium federal funds rate 2% above the annual inflation rate.
- The rule adjusts the equilibrium rate based on deviations in inflation and real GDP growth from targets set by the Federal Reserve.
- Overshooting targets increases the policy rate, while undershooting lowers it.
- The basic Taylor Rule formula does not cover negative interest rates or alternative monetary policy tools like asset purchases.
- Inflation remains the most significant factor in this formula, yet shifting it to reflect the dual mandate of stable prices and maximum employment is recommended.
Understanding the Taylor Rule
When John Taylor introduced his famous formula, he highlighted that it mirrored Fed policy accurately leading up to 1993. However, he also pointed out that it was more of a conceptual framework for considering policy adjustments rather than a strict or mechanical rule.
According to the rule, when inflation surpasses the Federal Reserve’s target, the federal funds rate should be higher, and conversely, it should be lower if inflation is below target. Similarly, higher than expected real GDP growth should command a higher interest rate, while shortfalls would command lowering it.
The Taylor Rule Formula
Taylor’s primary formula can be expressed as:
r = p + 0.5y + 0.5(p - 2) + 2
Where:
r= nominal fed funds ratep= inflation ratey= percent deviation between current real GDP and the long-term trend
This equation presupposes an equilibrium federal funds rate positioned 2% above inflation, encapsulated in the
Related Terms: monetary policy, real GDP, output gap, federal funds rate, inflation.
References
- The Brookings Institution. “The Taylor Rule: A Benchmark for Monetary Policy?”
- Taylor, John B. “Discretion Versus Policy Rules in Practice”. Carnegie-Rochester Conference Series on Public Policy, vol. 39, 1993, Page 195.
- Board of Governors of the Federal Reserve System. “Monetary Policy Report, June 17, 2022”, Pages 46-48.
- Board of Governors of the Federal Reserve System. “Monetary Policy Report, June 17, 2022”, Page 48.
- Board of Governors of the Federal Reserve System. “Revolution and Evolution in Central Bank Communications”.
- Board of Governors of the Federal Reserve System. “Monetary Policy Report, June 17, 2022”, Pages 1, 46.
- Taylor, John B. “Discretion Versus Policy Rules in Practice”. Carnegie-Rochester Conference Series on Public Policy, vol. 39, 1993, Pages 196-197.
