The Taylor rule is a mathematical formula developed by Stanford University economist John Taylor to provide guidance to the U.S. Federal Reserve and other central banks for setting short-term interest rates based on economic conditions, mainly inflation and economic growth or the unemployment rate.
According to the Federal Reserve Bank of San Francisco's website, the Taylor rule, which was formulated in 1993, states that real short-term interest rates—meaning, adjusted for inflation—should be determined by:
- where actual inflation is compared to the central bank's targeted level,
- how far the level of economic growth is above or below the level of full employment and
- what interest rate would be consistent with fostering full employment.
"The rule 'recommends' a relatively high interest rate (that is, a 'tight' monetary policy) when inflation is above its target or when the economy is above its full employment level, and a relatively low interest rate ('easy' monetary policy) in the opposite situations," the site explains.
According to a 28 April 2015 article written by Ben S. Bernanke, a distinguished fellow in residence at the Brookings Institution and former U.S. Federal Reserve Chair (2006-2014), the Taylor Rule "is a simple equation—essentially, a rule of thumb—that is intended to describe the interest rate decisions of the Federal Reserve's Federal Open Market Committee."
Per Bernanke, the mathematical formula for the rule is:
- r = p + .5y + .5(p – 2) + 2
- r is the federal funds rate
- p represents the rate of inflation
- y is the percent deviation of real GDP from the central bank's target
"The variable y in the Taylor rule can be interpreted as the excess of actual GDP over potential output, also known as the output gap," Bernanke explains.
Who Is Taylor?
According to a biography on Stanford's website, Taylor is the Mary and Robert Raymond professor of economics at the university. He is also a George P. Shultz senior fellow in economics at the Hoover Institution, a public policy think tank located at Stanford. Taylor served as Under Secretary of the Treasury for International Affairs (2001-2005) and was a member of the President's Council of Economic Advisers (1989-1991). He has won numerous professional and academic awards for his work in economics.
President Donald Trump reportedly considered Taylor to succeed Janet Yellen as Fed chair in 2017, but that position went to Jerome Powell. However, Taylor has been mentioned as a candidate for the vice chair seat, which remains unfilled (as of March 2018). He is also often mentioned as a possible future winner of the Nobel Prize for economics.
Why Is The Taylor Rule Important?
According to a paper published in February 2010 by the Federal Reserve Bank of Kansas City's economic research department entitled "The Taylor rule and the Practice of Central Banking," "the [Taylor rule] has advanced the practice of central banking."
"The Taylor rule has revolutionized the way many policymakers at central banks think about monetary policy," says the paper, which was written by Pier Francesco Asso of the University of Palermo, George A. Kahn of the Kansas City Fed, and Robert Leeson of the Hoover Institution. "Various versions of the Taylor Rule have been incorporated into macroeconomic models that are used at central banks to understand and forecast the economy."
The rule "has been widely used among policy makers as a guide for setting rates since [Taylor] developed it," Bloomberg News reported on 10 October 2017.
Competing Views On The Taylor Rule
The Taylor rule is generally favoured in the U.S. by fiscal conservatives. For example, legislation supported by Rep. Jeb Hensarling (R-Texas), the chairman of the House Financial Services Committee, would require the Fed to follow a policy rule like Taylor's in setting monetary policy and interest rates. The Fed would have to explain any deviation from the rule.
But not everyone in economic or political circles supports implementing Taylor's rule or something similar, for various reasons. One main reason is that since 2012, applying the rule would have meant higher U.S. interest rates than those actually set by the Fed, which some believe may have stifled economic growth. Many economists and policy makers also say that such a rule would limit the central bank's independence and flexibility, which could potentially harm the economy.
For example, when she was Fed chair, Janet Yellen told the House Financial Services Committee in July 2014 that "it would be a grave mistake for the Fed to commit to conduct monetary policy according to a mathematical rule." She continued, "It is utterly necessary for us to provide more monetary-policy accommodation than those simple rules would have suggested."
She was responding to the House bill that would have required the Fed to adopt a mathematical formula for setting the fed funds rate.
In November 2015, in a letter to the Speaker of the House, Rep. Paul Ryan (R-Wisconsin), and the House minority leader, Rep. Nancy Pelosi (D-California), Yellen reiterated her opposition to the proposed legislation, calling it "significantly flawed."
"The bill would severely impair the Federal Reserve's ability to carry out its congressional mandate and would be a grave mistake, detrimental to the economy and the American people," she said in the letter. The bill never became law.
Bernanke, Yellen's predecessor at the Fed, is also opposed to implementing the Taylor rule to formulate Fed interest rate policy. "Monetary policy should be systematic, not automatic," he said in the Brookings paper. "The simplicity of the Taylor rule disguises the complexity of the underlying judgments that FOMC members must continually make if they are to make good policy decisions. I don't think we'll be replacing the FOMC with robots anytime soon. I certainly hope not."
The Taylor rule is a mathematical formula developed by Stanford University economist John Taylor to help central banks set short-term interest rates based on economic conditions and inflation.
Proponents of the rule say it would force central banks to make dispassionate decisions divorced from politics and other factors outside economics, while opponents say it would limit central bank flexibility in making monetary policy. Nevertheless, the rule has been used by central banks since it was devised in 1993 to guide their decision making.
Senior Market Specialist
Russell Shor (MSTA, CFTe, MFTA) is a Senior Market Specialist at FXCM. He joined the firm in October 2017 and has an Honours Degree in Economics from the University of South Africa and holds the coveted Certified Financial Technician and Master of Financial Technical Analysis qualifications from the International Federation…