The Taylor Rule - Explained

What is Taylor's Rule?

Updated at March 29th, 2023

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What is the Taylor Rule?

Taylor's rule is a mathematical formula intended to serve as a guideline for the U.S. Federal Reserve and other central banks for adjusting interest rates in the short-term in response to changes in economic conditions such as inflation and the unemployment rate. This rule is named after John B. Taylor, an economist at Stanford University, who introduced it in 1993 with the goal of adjusting and setting judicious interest rates that not only helped in stabilizing the economy in the short-term, but also fostered long-term growth. According to Taylors rule, there are three determinants of real short-term interest rates (i.e. interest rate adjusted for inflation)

The targeted level of inflation in relation to the actual inflation levels.
The actual levels of employment in relation to full employment.
An interest rate that is appropriately consistent with full employment in the short term.

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How does the Taylor Rule Work?

Taylors rule is extensively used to forecast future interest rates with different values of economic variables such as population, poverty rate and inflation as input. Results obtained by the application of this rule are intended to serve as guidelines for the Federal Reserve to make changes to its interest rates according to prevalent parameters such as inflation and the employment rate. The rules of thumb in the application of Taylors rule are as follows:

Interest rates should be raised during periods of high inflation or in instances where employment surpasses full employment levels.
Conversely, interest rates should be lowered during periods of low inflation and /or low employment levels.

A Brief Timeline of Taylor's Rule

1993: Taylors Rule was invented and published by John Brian Taylor (1946 - ), an economist and academician at Stanford University. The same year, fellow economists, Dale W. Henderson of Georgetown University and Warwick McKibbin of the Australian National University proposed the same rule. 1999: John Taylor adapted and updated Taylors Rule. 2003: Athanasios Orphanides, a prominent economist from Cyprus, publicized his reservations against incorporating Taylors Rule in policy making since, according to him, the rule would not hold up to real-time data (RTD). 2015: Ben Shalom Bernanke, who had served two terms as Chair of the Federal Reserve, endorsed Taylors Rule in an article published in April, 2015. The same year, William Hunt Gross, an American investor, advocated a total abandonment of Taylors Rule, citing that low interest rates were not the solution for decreased growth. 2017: The Financial CHOICE Act of 2017 mandated a rigid version of Taylors Rule known as Directive Policy Rule (DPR) for the Fed to follow. The proposed DPR was met with strong opposition by economists, including John Taylor himself, who was averse to the use of his rule as a mechanical formula. Taylor, instead, advocated a much more informal implementation and operation of Taylors Rule by policymakers.

Taylors Rule as an Equation

John Taylor's original version of the rule can be represented mathematically as follows: it = t + r*t + (t - *t) + y(yt - t) where, it is the target short-term nominal interest rate, t is the inflation rate according to the GDP deflator, *t is the desired rate of inflation, r*t is the assumed equilibrium real rate of interest, yt is the logarithm of real GDP, and t is the potential output logarithm, as determined by a linear trend. Also, according to Taylor's original paper, both and y should have positive values with the proposal that = y= 0.5. In 2015, Ben Shalom Bernanke proposed a simplified formula of Taylors Rule as follows. r = p + 0.5y + 0.5(p 2) + 2, where, r is the federal funds rate of interest, p is the inflation rate, and y is the percent deviation of real GDP from the desired GDP. From the above equations, it is possible to draw a simple inference from Taylors Rule, which is that inflation is merely the difference between the real interest rate and thenominal interest rate. While real interest rates do factor in inflation, nominal interest rates do not. Although the primary purpose of Taylors Rule is to scrutinize potential targets for interest rates, the same is not possible without considering the all-important economic variable of inflation. However, it is vital to form a comprehensive understanding of the economy vis--vis prices in order to draw an accurate comparison between inflation and non-inflation rates. Widespread disagreements still persist among experts regarding the veracity of Taylors Rule while some prominent economists, including policymakers have publicly endorsed John Taylors original proposition or a modified version of the same, others have opposed any form of implementation of the rule. Detractors have vehemently cited shortcomings such as inaccuracies while using real-time data as well as the alleged inability of the rule to adjust to sudden or drastic changes in the economy. Nevertheless, it is beyond doubt that Taylors Rule has by far, vastly improved the practice of central banking as a whole, despite the irony that the Federal Reserve the institution for which it was created in the first place does not explicitly follow it.

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