The Taylor Rule: An Economic Model for Monetary Policy

The Taylor Rule is an interest rate formula invented by famed economist John Taylor in 1992 and outlined in his 1993 study, "Discretion Versus Policy Rules in Practice." It suggests how central banks should change interest rates to account for inflation and other economic conditions.

The Taylor Rule suggests that the Federal Reserve should raise rates when inflation is above target or when gross domestic product (GDP) growth is above potential. It also suggests that the Fed should lower rates when inflation is below the target level or when GDP growth below potential.

The Taylor Rule Formula

$\begin{aligned} &I = R ^ {*} + PI + {0.5} \left ( PI - PI ^ * \right ) + {0.5} \left ( Y - Y ^ * \right ) \\ &\textbf{where:}\\ &I = \text{Nominal fed funds rate} \\ &R ^ * = \text{Real federal funds rate (usually\ 2\%)} \\ π = \text{Rate of inflation} \\ π ^ * = \text{Target inflation rate} \\ &Y = \text{Logarithm of real output} \\ &Y ^ * = \text{Logarithm of potential output} \\ \end{aligned}$π=Rate of inflationπ∗=Target inflation rate​I=R∗+PI+0.5(PI−PI∗)+0.5(Y−Y∗)where:I=Nominal fed funds rateR∗=Real federal funds rate (usually 2%)Y=Logarithm of real outputY∗=Logarithm of potential output​

The Taylor Rule Explained

The Taylor Rule is based on three numbers: an interest rate, an inflation rate and a GDP rate, all based on an equilibrium rate to gauge the proper balance for an interest rate forecast by monetary authorities.

This formula suggests that the difference between a nominal interest rate and a real interest rate is inflation. Real interest rates account for inflation while nominal rates do not. To compare rates of inflation, one must look at the factors that drive it.

Since its inception, the Taylor Rule has served not only as a gauge of interest rates, inflation, and output levels, but also as a guide to gauge proper levels of the money supply.

Three Factors That Drive Inflation

Prices and inflation are driven by three factors: the consumer price index (CPI), producer prices, and the employment index. Most nations in the modern day look at CPI as a whole rather than at core CPI, which excludes food and energy prices.

Rising prices mean higher inflation, so Taylor recommended factoring the rate of inflation over one year (or four quarters) for a comprehensive picture.

Taylor also recommended the real interest rate should be 1.5 times the inflation rate. This is based on the assumption of an equilibrium rate that factors the real inflation rate against the expected inflation rate. Taylor called this the equilibrium, a 2% steady state, equal to a rate of about 2%. But that's only part of the equation—output must be factored in as well.

To properly gauge inflation and price levels, apply a moving average of the various price levels to determine a trend and to smooth out fluctuations. Perform the same functions on a monthly interest rate chart. Follow the fed funds rate to determine trends.

Determining Total Economic Output

The total output of an economy can be determined by productivity, labor force participation, and changes in employment. For the Taylor Rule calculation, we look at real output against potential output.

The Taylor Rule looks at GDP in terms of real and nominal GDP, or what Taylor called actual and trend GDP. It factors in the GDP deflater, which measures prices of all goods produced domestically. We do this by dividing nominal GDP by real GDP and multiplying this figure by 100.

The answer is the figure for real GDP. We are deflating nominal GDP into a true number to fully measure total output of an economy.

When inflation is on target and GDP is growing at its potential, rates are said to be neutral. This model aims to stabilize the economy in the short term and to stabilize inflation over the long term.

The Taylor Rule and Asset Bubbles

Some people thought the central bank was to blame—at least partly—for the housing crisis in 2007-2008. They assert that interest rates were kept too low in the years following the dot-com bubble and leading up to the housing market crash in 2008.

Interest rates that are too low can contribute to asset bubbles. The thinking went, interest rates must be raised to balance inflation and output levels. Another problem linked to asset bubbles is that money supply levels may rise at a pace far higher than what is needed to balance an economy suffering from inflation and output imbalances.

Had the central bank followed the Taylor rule during this time, which indicated the interest rate should be much higher, the bubble may have been smaller, as less people would have been incentivized to buy homes. 

The Bottom Line

The Taylor Rule is a formula developed by economist John Taylor that suggests how central banks should set the federal funds rate. The formula ties target rates to the metrics of inflation and GDP growth.

The Taylor Rule recommends dropping the federal funds rate when GDP growth and inflation fall below expectations, and raising them when GDP growth and inflation exceed them.