Order Code RS21821
Updated October 4, 2007
Evaluating the Current Stance of Monetary
Policy Using a Taylor Rule
Marc Labonte
Specialist in Macroeconomics
Government and Finance Division
Summary
Oversight of the Federal Reserve’s (Fed’s) monetary policy decisions rests with
Congress. But oversight is encumbered by the absence of a straightforward relationship
between interest rates and economic performance. The Fed’s policy decisions are
discretionary, meaning there is no objective, transparent “yardstick” for evaluating their
decisions; this also hampers oversight. A simple rule of thumb guide to monetary policy
decisions called a “Taylor rule” is an intuitive way to judge actual policy against some
objective, albeit simplistic, ideal. Taylor rules are flexible enough to be adjusted to
reflect a wide variety of policy goals. This report compares current policy to a number
of Taylor rules, and finds that interest rates are currently lower than most rules would
prescribe. This report will be updated as events warrant.
The government has two main tools for influencing overall economic conditions,
fiscal policy and monetary policy. Monetary policy can boost economic activity and
inflation by lowering short-term interest rates (the federal funds rate), or depress
economic activity and inflation by raising interest rates. Changes in output and
employment caused by monetary policy are of a temporary nature: in the long run,
changes in the money supply affect only inflation and have no effect on the economy’s
sustainable growth rate. In essence, monetary policy has two attainable goals: to promote
economic stability (minimize fluctuations in the business cycle) and price stability (low
and stable inflation). Because the Fed has only one tool at its disposal, influence over
interest rates, it faces a tradeoff in the pursuit of these two goals — when the two goals
conflict, they cannot both be pursued at once.1
Congress has delegated responsibility for monetary policy decisions to the Federal
Reserve, but maintains oversight responsibilities. Oversight is made difficult, however,
by the absence of a straightforward relationship between interest rates and economic
performance. Because of changes in investment demand, any given interest rate may be
1 For more information, see CRS Report RL30354, Monetary Policy: Current Status and
Conditions, by Marc Labonte and Gail Makinen.

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expansionary when the economy is booming, but contractionary when the economy is in
recession. Furthermore, the Fed’s policy decisions are discretionary: it justifies policy
decisions qualitatively rather than quantitatively. Its decisions to change interest rates
need only be consistent with the broad mandate that it maintain full employment, stable
prices, and moderate interest rates. When these goals are mutually exclusive, as they
frequently are, the mandate can be used to justify virtually any policy decision. In this
context, Congress frequently finds itself in a position where it must “take the Fed’s word
for it” that the policy change will have the effect it is said to have because there is no
objective outside “yardstick” to evaluate it. This report attempts to offer such a yardstick.
One way to evaluate Fed policy for oversight purposes would be to use complex
econometric models to generate predicted results of a monetary policy change, and see if
these results conform with the policy change’s stated or mandated goals. But this requires
sophisticated knowledge of econometric modeling that may not be practical for oversight,
particularly since different models yield significantly different results. This report uses
a simpler, popular alternative called a “Taylor rule” to quantitatively evaluate the current
stance of monetary policy.2 Economist John Taylor, recently a Treasury Undersecretary,
proposed the following rule to set interest rates that balances the goals of maintaining
economic stability and price stability:3
FFR = (R + I) + 0.5 x (output gap) + 0.5 x (I - IT)
where:
FFR = federal funds rate
R = equilibrium interest rate (assumed here to equal 2)
output gap = percent difference between actual GDP and potential GDP
I = inflation rate
IT = inflation target (assumed here to equal 2)
The goal of maintaining economic stability is represented by the factor 0.5 x (output
gap), which raises interest rates when actual GDP is greater than potential GDP and
lowers rates when it is below potential. The output gap is the difference between actual
and potential GDP. Potential GDP is the level of output that would be produced if all of
the economy’s labor and capital resources were being utilized; in economic downturns,
actual GDP falls below potential because some resources are idle. Likewise, because
prices adjust slowly, the economy can temporarily be pushed above a level of output that
is sustainable. Once prices adjust, output will return to potential. There is no direct way
to measure potential GDP, so it must be inferred; different estimating methods yield
different results.4 This Taylor rule states that when actual GDP is, say, 1% above
potential GDP, the federal funds rate should be increased by 0.5 percentage points. If
2 For background and analysis of Taylor rules, see CRS Report RL31050, Formulation of
Monetary Policy by the Federal Reserve: Rules vs. Discretion, by Marc Labonte.
3 John Taylor, “Discretion vs. Policy Rules in Practice,” Carnegie-Rochester Series on Public
Policy, vol. 39, 1993, p. 195; Robert Solow and John Taylor, Inflation, Unemployment, and
Monetary Policy (Cambridge, MA: MIT Press, 1998), p. 45. The specific mathematical form of
this rule does not appear to be formally derived from theory or empirical evidence.
4 This report uses CBO’s estimate of potential GDP. See Congressional Budget Office, CBO’s
Method for Estimating Potential Output, August 2001.

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policymakers wanted a more (less) aggressive reaction to changes in growth, they would
place a larger (smaller) weight on the coefficient than 0.5.
The goal of maintaining price stability is represented by the factor 0.5 x (I-IT), which
states that interest rates are to be raised when inflation (I) is above its target (IT) and
lowered when inflation is below its target. Unlike the output gap, the inflation target can
be any rate that policymakers desire. This rule assumes a 2% inflation target, which is
close to the 1994-2003 average of 1.8%, as measured by the GDP deflator. (As measured
by the consumer price index (CPI), the 10-year average inflation rate is 2.5%.) This rule
weights the response to deviations from the inflation target equally to deviations from
potential GDP: a one percentage point increase in inflation above its target would lead to
a 0.5 percentage point increase in the federal funds rate. If actual GDP is equal to
potential GDP and inflation is equal to its target, the rule calls for an inflation-adjusted
federal funds rate of 2%, or an actual federal funds rate equal to 2% plus the current
inflation rate. This is often called the “neutral” interest rate, at which monetary policy is
neither stimulative nor contractionary.
Current Policy Prescriptions According to Different Taylor Rules
In the second quarter of 2007, actual GDP was 0.2% below potential GDP and
inflation (using the GDP deflator) equaled 2.7% over the previous four quarters. Entering
these data into the Taylor rule above (and rounding to the nearest quarter point) yields a
federal funds rate of (2% + 2.7%) + 0.5 x (-0.2%) + 0.5 x (2.7% - 2%) = 5%, higher than
the current rate of 4.75%. With inflation at 2.7%, the current neutral rate is 4.75%,
according to the rule. The Taylor rule calls for an interest rate a little above the neutral
rate because the above-target inflation rate slightly outweighs the output gap currently.
Since this rule considers only inflation and the output gap, it cannot consider other factors
that counsel against tightening policy, such as the potential for financial turmoil in August
2007 to slow future growth.5
Figure 1 plots actual federal funds rates against rates determined by the Taylor rule
from 1998 to 2003. This figure should not be used to directly evaluate actual policy for
two reasons. First, because economic data are released with a lag and subject to
subsequent revisions, Figure 1 is based on data unavailable to the Fed when actual policy
decisions were made.6 Second, since subsequent events would have differed had a
different monetary path been followed at any given point, the chart cannot be interpreted
as a consistent alternative policy option over time.
5 A major drawback to Taylor rules is that they cannot cover all contingencies. For example, in
times of crisis, the other goal of monetary policy, to act as a lender of last resort, could not be
adequately executed by a rule. Arguably, the Fed’s more aggressive stance in 2001 than the rule
would suggest was partly motivated by the unique circumstances surrounding September 11,
which a rule cannot take into account. On the other hand, some economists argues that, because
of uncertainty over the proper way to model economic activity, simple rules perform more
robustly than complex rules across different models.
6 Athanasios Orphanides, “Monetary Policy Rules Based on Real-Time Data,” Federal Reserve
Board of Governors, Finance and Economics Discussion Series 3, 1998.

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As can be seen in Figure 1, while interest rates under this rule followed the same
general pattern as actual rates — monetary tightening in the 1990s followed by easing in
the 2000s — there were some short-term differences. The rule called for lower interest
rates in 1998 because inflation was below the target. The rule called for similar interest
rates in 1999-2000, but a less aggressive policy response to the economic downturn that
began in 2001. (If the rule was based on data available at the time, the rate reduction
would have been even smaller since the GDP data have since been revised downward.)
This rule would have tightened policy slightly in the second half of 2003 as the economy
picked up speed, rather than leaving interest rates at 1% as the Fed did.
Figure 1. Federal Funds Rate, Actual and Prescribed by Taylor Rule,
1998-2003
7%
6%
5%
te
a 4%
t r
s 3%
re
te 2%
in
1%
0%
1998-I
1999-I
2000-I
2001-I
2002-I
2003-I
Actual
Taylor rule
Source: CRS calculations based on Federal Reserve, BEA, CBO data.
The Taylor Rule used so far is one out of an unlimited number of possibilities. It is
useful to see in Table 1 how other rules based on different policy goals compare to
current policy. For example, economist Lars Svensson argues that since monetary policy
affects the economy with a lag, if policy is based on current data it will always be
backward looking, and “fighting the last war.” Since policy decisions made today affect
future economic conditions, he argues they should be based on projections of future
growth and inflation.7 Of course, different forecasters have different projections of future
growth, but this problem can be mitigated by using the Blue Chip “consensus forecast.”
Blue Chip is a private company whose monthly consensus forecast is the average forecast
of 50 different private sector forecasters. Based on the September 2007 consensus
forecast, GDP one year from now is projected to be 0.3% below potential GDP and
inflation will fall to 2.2%. A rule with the same weights as the “Traditional” Taylor rule
above calls for a current federal funds rate of 4.25%. Of the Taylor rules considered, this
7 Lars Svensson, Inflation Forecast Targeting: Implementing and Monitoring Inflation Targets,
National Bureau of Economic Research, Working Paper no. 5797, October 1996.

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one prescribes the lowest interest rates, because forecasters believe that inflation will fall
despite its recent rise.
Table 1. Current Policy According to Various Taylor Rules
Current Interest
Type of Rule
Rate Predicted by
Federal Funds Rate =
(See text for details)
Rule
(Actual=4.75%)
Traditional Taylor Rule
(2+I) + 0.5 x (output gap) + 0.5 x (I-2)
5%
Taylor Rule based on forecast
(2+I) + 0.5 x (output gap
) + 0.5 x (I
-2)
4.25%
proj
proj.
“Strict” Inflation Target
(2+I) + 1.0 x (I-2)
5.25%
“Fine tuning” Taylor Rule
(2+I) + 1.0 x (output gap) + 1.0 x (I-2)
5%
Taylor Rule based on history
(2.2+I) + 0.8 x (output gap) + 0.5 x (I-2)
5%
Source: CRS calculations based on quarterly data from BEA, Federal Reserve, CBO, Blue Chip.
Note: FFR = federal funds rate; output gap = percent difference between actual GDP and potential GDP; I = inflation
rate, measured by GDP deflator. Results are rounded to nearest quarter point.
Making price stability the sole goal of monetary policy (inflation targeting) has been
widely implemented abroad in economies such as the United Kingdom and the euro area,
and bills to switch to inflation targeting have been introduced in the 109th Congress (H.R.
498).8 Proponents support inflation targets for three reasons related to this report. First,
many economists have reservations with “fine tuning” in monetary policy. Since the Fed
can make mistakes and markets can (eventually) adjust on their own, they argue that the
best monetary policy is a “hands off” one that does not try to respond to every small
change in the economy. Second, some economists have argued that monetary policy
should focus less on stabilizing output since only the inflationary effects of monetary
policy are permanent. Third, in the context of a Taylor Rule, a strict inflation target could
be justified on the grounds that measurements of the output gap are too uncertain to be
useful (as discussed below).9
To see how a “strict” inflation target would operate, the traditional Taylor rule can
be adapted by removing the output gap and increasing the weight on the inflation target
to, say, 1.0.10 Under this rule, the current interest rate would equal 5.25% — above the
equilibrium rate because inflation is 0.7 percentage points above its presumed target.
When inflation does not follow the business cycle closely, a strict inflation rule causes
8 See CRS Report 98-16, Should the Federal Reserve Adopt an Inflation Target?, by Marc
Labonte and Gail Makinen.
9 Bennett McCallum, Should Monetary Policy Respond Strongly to Output Gaps?, National
Bureau of Economic Research, Working Paper no. 5952, April 2001.
10 The output gap might not be removed if future (rather than current) inflation were targeted
under a strict inflation target. In that case, the rule might still react to changes in the output gap
in so far as changes in the output gap affect future inflation. See Laurence Ball, Efficient Rules
for Monetary Policy, National Bureau of Economic Research, Working Paper no. 5952, March
1997.

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monetary policy to become less counter-cyclical, and this rule would not have followed
actual policy very closely in the past few years. As practiced abroad, monetary policy has
still attempted to stabilize economic growth under an inflation target, usually under the
principle that stable growth helps maintain stable prices. Therefore, the strict inflation
target used here does not reflect international experience with inflation targeting.11
Alternatively, policymakers may prefer a more aggressive response to changes in
economic conditions — more “fine tuning” — than the traditional Taylor Rule provides.
More fine tuning can be incorporated by raising both coefficients on the original rule from
0.5 to, say, 1.0. When this change is made, the current interest rate would be 5% (see
Table 1).
As has been discussed, there are an unlimited number of weights that can be placed
on the inflation and output factors because there are an unlimited variety of policy
preferences. Rather than arbitrarily assigning a set of preferences to the Taylor rule,
another approach is to determine what weights best parallel actual Federal Reserve policy
historically. Taylor does this in a 1999 paper and shows that a Taylor rule has a high
goodness of fit (the R-squared is 0.83 and the coefficients are highly statistically
significant) in the Greenspan era.12 In other words, most of the decisions that the Fed
made in the Greenspan era through the third quarter of 1997 are the same as if the Fed had
been following a Taylor rule; this is reassuring for the use of Taylor rules to aid oversight.
The “historical” Taylor rule turns out to have similar weights to the “traditional” one
suggested by Taylor: the weight on the output gap would be raised from 0.5 to 0.8 and the
weight on inflation would remain 0.5. The real equilibrium interest rate is slightly higher
in this period (2.2%) than assumed in the original Taylor rule (2%). A comparison of
current interest rates and those predicted by this “historical” Taylor rule can be interpreted
as showing whether current monetary policy decisions are similar to ones taken by the Fed
in the past. If the Fed had continued its historical behavior, interest rates would have
tended to be a little higher than they actually were since the second half of 2003, and
interest rates would currently be 5% (see Table 1).
One drawback to evaluating monetary policy using a Taylor rule is that the policy
prescriptions made by the Taylor rule are very sensitive to the choice of data sources and
coefficient weights. In particular, since the output gap is a constructed series that can be
estimated using a number of different methods, different output gap series produce widely
different results. Likewise, there are several equally valid measures of inflation available,
and sometimes these series diverge for short periods of time. Kozicki shows that different
data sources can change the Taylor rule’s recommended interest rate by as many as
several percentage points.13 Discretionary policy is able to weigh conflicting data in a
way that a rule cannot. Nevertheless, discretionary policy still must be based on the same
conflicting data as rules, so this advantage should not be overestimated.
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11 See CRS Report RL31702, Price Stability (Inflation Targeting) as the Sole Goal of Monetary
Policy: The International Experience, by Marc Labonte and Gail Makinen.
12 John Taylor, “A Historical Analysis of Monetary Policy Rules,” in John Taylor, ed., Monetary
Policy Rules (Chicago: University of Chicago Press, 1999), p. 319.
13 Sharon Kozicki, “How Useful are Taylor Rules for Monetary Policy?,” Federal Reserve Bank
of Kansas City Economic Review, vol. 84, no. 2 (1999:2), p. 5.

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