RateWatch #265 - Taylor Rule

August 25, 2001

Taylor's Rule

The Fed has been aggressively easing to the point where is may be pushing the overnight rate down to the level of inflation so that, in effect, real interest rates are very low. Of interest is the rule that the Fed has traditionally used to calculate what the overnight rate should be - Taylor's rule. Taylor's Rule is named for Dr. John B. Taylor a professor of economics at Stanford. The Taylor rule is an attempt to formalize how the Fed moves the overnight rate in response to the measurement of two key things

1) inflation and
2) GDP growth. Recall that the assignment given to the Fed is: "Keep the economy growing at a moderate pace while keeping inflation low." A scholarly presentation of this is available in Acrobat format at
http://www.frbsf.org/econrsrch/econrev/98-3/3-16.pdf
A somewhat more readable version is at: http://www.frbsf.org/econrsrch/wklyltr/wklyltr98/el98-38.html

We will present here the skinny view. The Taylor rule is best regarded as a scientific explanation attempting to quantify the behavior of the Fed by postulating a mathematical equation of the Fed's "reaction function". That is, if one analyzes the data: interest rates, inflation and GDP can one determine a rule that describes the Fed's behavior.

The specific and simple rule is based on the following

r = the equilibrium real fed funds rate (the "natural" rate that is consistent with full-employment)

I = the average inflation rate for the past 4 quarters

(note here that inflation is not CPI but the GDP deflator - this was discussed in RateWatch #147)

I* = the target inflation rate

y = the output gap (100*(real GDP - potential GDP)/potential GDP)

The equation is Fed Funds Rate = r + I +0.5(I-I*) +0.5y

If, for example, the target inflation rate was 2% and inflation (as measured by GDP deflator is 3%) then the Fed funds rate should be 2 + 3 + 0.5(3-2) = 5.5%. In addition, if there is an output gap i.e. a difference between real GDP growth and "potential" GDP growth (a somewhat elusive concept) rates must be adjusted accordingly. If GDP growth exceeds "potential" then rates must be increased. In practice there are several major considerations. The Fed would like to react to the data slowly by adjusting the overnight rate slowly. The goal is the goal legislated for our monetary policy - stable prices and full employment. This year the "slow change" rule has been cast aside because of the current fear of recession.

In the present situation the question is whether the Fed is easing, or will ease too much later this year. Just something else to worry about.

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