Taylor's Rule

Taylor’s rule is a proposed guideline for how central banks, such as the Federal Reserve, should alter interest rates in response to changes in economic conditions. Taylor’s rule, introduced by economist John Taylor, was established to adjust and set prudent rates for the short-term stabilization of the economy, while still maintaining long-term growth. The rule is based on three factors:

1) Targeted versus actual inflation levels;

2) Full employment versus actual employment levels;

3) The short-term interest rate appropriately consistent with full employment.

Taylor's rule is essentially a forecasting model used to determine what interest rates will be, or should be, as shifts in the economy occur. Taylor’s rule makes the recommendation that the Federal Reserve should raise interest rates when inflation is high or when employment exceeds full employment levels. Conversely, when inflation and employment levels are low, interest rates should be decreased.

Taylor’s rule was invented and published from 1992 to 1993 by John Taylor, a Stanford economist, who outlined the rule in his precedent-setting 1993 study “Discretion vs. Policy Rules in Practice.” Taylor continued to perfect the rule and made amendments to the formula in 1999.

The equation, with some alterations, used by central banks under Taylor’s rule looks like:

i = r* + pi + 0.5 (pi-pi*) + 0.5 (y-y*)

Where:

i = nominal fed funds rate

r* = real federal funds rate (usually 2%)

pi = rate of inflation

p* = target inflation rate

Y = logarithm of real output

y* = logarithm of potential output

In more simple terms, this equation is saying inflation is the difference between a real and a nominal interest rate. Real interest rates are inclusive of inflation in their factoring, while nominal rates are not. The equation’s purpose is to look at potential targets for interest rates; however, such a task is impossible without looking at inflation. To compare inflation and non-inflation rates, the total spectrum of an economy must be observed in terms of prices. Variations are often made to this formula based on what central bankers determine are the most important factors to include.

For many, the jury is out on Taylor’s rule as it comes with several drawbacks, the most serious being it cannot account for sudden jolts or turns in the economy, such as a stock or housing market crash. While several issues with the rule are, as yet, unresolved, many central banks find Taylor’s rule a favorable practice and extensive research indicates the rule has upgraded the practice of central banking as a whole.