Taylor Rule Economics: How to Use the Taylor Rule Formula

In macroeconomics, the Taylor rule is a formula that ties a central bank’s federal funds rates to current economic growth rates and inflation rates. Economist John B. Taylor, who earned a PhD from Stanford University, developed this fiscal policy formula in 1993, which assumes an equilibrium federal funds rate two percent above annual inflation. It adjusts this equilibrium rate based on fluctuations in inflation due to times of financial crisis or economic boom and full employment.

Overshooting target inflation rates raise the policy rate under the Taylor rule, while shortfalls lower it. While it can be helpful in understanding price levels, financial markets’ performance, and overall gross domestic product (GDP), the Taylor rule formula does not consider the ineffectiveness of negative interest rates or other monetary policy tools, such as asset purchases.

The Taylor rule makes actual inflation rates the most crucial determiner in monetary policy rules to control the money supply. This rule dictates inflation is the prime factor in setting real rates. Still, the United States Federal Reserve has a dual mandate to promote stable prices and lower unemployment rates.

Economist John Taylor introduced his formula as more of a guideline. This monetary economics concept could not perfectly sum up the totality of economic activity and how it affects public policy. Instead, it prescribes higher federal fund rates when inflation exceeds the Fed’s inflation target. Similarly, the rule proposes a lower fund rate if inflation is low. The real GDP should reflect real interest rates, giving policymakers a benchmark for when to raise and lower percentage points to reflect the economy’s needs.

You can write the Taylor rule formulaically like this: r = p + 0.5y + 0.5(p - 2) + 2.

• r = nominal interest rate
• p = the rate of inflation
• y = the percent deviation between the current real GDP and the long-term trend in GDP

The formula provides fast, real-time data for determining interest rates. In times of volatility, the formula can be a good predictor of a short-term interest rate. It assumes a two percent equilibrium federal funds rate two percent above inflation. The second 0.5 coefficient assumes the federal funds rate will increase or decrease by half the difference between the actual and target inflation rate. In this formula, the output gap is also a factor, acting as the difference between the actual and targeted real GDP growth.

Economists find the Taylor rule operates as a reliable benchmark during times of steady or nominal GDP growth and low volatility. During these times, the Federal Reserve System and consumer prices remain relatively predictable.

The Taylor rule becomes less reliable in times of enormous volatility. The formula, and other versions of the Taylor rule, predicted extremely low-interest rates following the COVID-19 recession. In reality, the rates were not as low, which is true of some other periods of economic downfall. The formula does not consider expenditures like large-scale asset purchases or other risk management principles.

There are some variants to the Taylor rule that economists can employ for more precise rate prediction, as the general formula always assumes a two percent interest rate above inflation. During her time as Federal Reserve Vice Chair, Janet Yellen modified the Taylor rule to give equal weight to deviations from the Fed’s inflation and growth targets.

Former Federal Reserve Chairman Ben Bernanke noted the Fed would more likely trust Taylor’s formula when doubling the output gap factor relative to inflation, making it more consistent with the Fed’s dual mandate to promote stable prices and full employment.

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