Monetary Policy and the Taylor Rule

Monetary Policy and the Taylor Rule

July 9, 2014
Monetary Policy and the Taylor Rule
Overview
Changes in inflation enter the Taylor rule in two places.
Some Members of Congress, dissatisfied with the Federal
First, the nominal neutral rate rises with inflation (in order
Reserve’s (Fed’s) conduct of monetary policy, have looked
to keep the inflation-adjusted neutral rate constant). Second,
for alternatives to the current regime. H.R. 5018 would
the goal of maintaining price stability is represented by the
trigger congressional and GAO oversight when interest
factor 0.5 x (I-IT), which states that the FFR should be 0.5
rates deviated from a Taylor rule. This In Focus provides a
percentage points above the inflation-adjusted neutral rate
brief description of the Taylor rule and its potential uses.
for every percentage point that inflation (I) is above its
target (IT), and lowered by the same proportion when
What Is a Taylor Rule?
inflation is below its target. Unlike the output gap, the
Normally, the Fed carries out monetary policy primarily by
inflation target can be set at any rate desired. For
setting a target for the federal funds rate, the overnight
illustration, it is set at 2% inflation here, which is the Fed’s
inter-bank lending rate. The Taylor rule was developed by
longer-term goal for inflation.
economist John Taylor to describe and evaluate the Fed’s
interest rate decisions. It is a simple mathematical formula
While a specific example has been provided here for
that, in the best known version, relates interest rate changes
illustrative purposes, a Taylor rule could include other
to changes in the inflation rate and the output gap. These
variables, and any of the parameters (R, IT, and the weights
two factors directly relate to the Fed’s statutory mandate to
on the output gap and inflation) could be set at any level.
achieve “maximum employment and stable prices.” The
best known version of this rule is:
How Are Taylor Rules Currently Used?
Taylor rules are currently used in economic analysis to
FFR = (R + I) + 0.5 x (output gap) + 0.5 x (I - IT)
explain the Fed’s past actions or to offer a baseline in an
evaluation of what the Fed has done or should do in the
where:
future. A Taylor rule (although with different parameters
from this example) has been demonstrated to track actual
FFR = federal funds rate
policy relatively well for the period lasting from after
R = equilibrium real interest rate (assumed here to
inflation declined in the 1980s to the beginning of the
equal 2)
financial crisis in 2007. Thus, it can be used in an economic
output gap = percent difference between actual
model (which offers a simplified version of the actual
GDP and potential GDP
economy) to represent the Fed’s decisions under normal
I = inflation rate
economic conditions.
IT = inflation target (assumed here to equal 2)
A limitation of the Taylor rule is that it was designed only
If actual GDP is equal to potential GDP and inflation is
to be used with the FFR, which was the Fed’s primary
equal to its target, this rule calls for the federal funds rate to
monetary policy instrument from roughly the early 1990s to
be 2% above the current inflation rate (because R = 2%).
late 2008. Since December 2008, the Fed has not used the
This is called the “neutral” interest rate, at which monetary
FFR as its primary policy tool because the FFR has been at
policy is neither stimulative nor contractionary.
the “zero lower bound”—it has been set near zero, and thus
cannot be lowered further. Instead, the Fed has created new
The goal of achieving maximum employment is represented
policy tools to stimulate the economy. The Taylor rule
by the factor 0.5 x (output gap). The output gap is the
cannot make policy prescriptions at the zero lower bound—
difference between actual and potential GDP. Potential
different combinations of deflation (falling prices) and
GDP is the level of output that would be produced if all of
output gaps would prescribe a negative federal funds rate
the economy’s labor and capital resources were being used.
under the Taylor rule, but that prescription would not be
In economic downturns, actual GDP falls below potential
actionable. The Taylor rule was devised at a time when
because some resources are idle; likewise, the economy can
interest rates had never fallen to the zero bound before, and
temporarily be pushed above a level of output that is
it arguably seemed reasonable at the time to assume that the
sustainable. In this rule, when the economy is below full
rule would not need to cover this contingency.
employment, the output gap is expressed as a negative
number, calling for lower interest rates. This Taylor rule
Could the Fed Use a Taylor Rule to
states that when actual GDP is, say, 1% below potential
Conduct Monetary Policy?
GDP, the federal funds rate should be 0.5 percentage points
Economists and policy analysts have debated whether
below the neutral rate.
basing monetary policy on a Taylor rule would lead to
better economic outcomes than the status quo.
Currently, Congress has granted the Fed broad
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Monetary Policy and the Taylor Rule
discretion to conduct monetary policy as it sees fit as
Taylor rule, but would potentially reintroduce policy
long as it strives to meet its statutory mandate. This
discretion. Further, if perceived policy errors by the Fed
discretion includes autonomy over what policy tools to
were mainly caused by forecasting errors (e.g., the failure to
use (e.g., whether policy should be carried out by
identify the housing bubble), then using a Taylor rule based
targeting the federal funds rate) and what the stance of
on forecasts would probably not have prevented them.
monetary policy should be (e.g., at what level should the
federal funds rate be set?).
Other practical challenges with formalizing use of the
traditional Taylor rule include (1) requisite data are released
The Fed already uses the Taylor rule as a reference tool to
with lags and later revised; (2) the neutral rate of interest
help inform its policy decisions. Proponents would like the
and potential output growth cannot be directly observed and
Taylor rule to have a more formal role in policymaking,
may vary over time, making them difficult to estimate
either requiring policy to be set by a Taylor rule or
accurately in real time; (3) basing the FFR on only inflation
requiring the Fed to explain its decisions relative to a
and the output gap would make it more volatile; (4) public
Taylor rule. If the Fed desired, it could arguably adopt these
comprehension; and (5) addressing the zero bound issue.
proposals voluntarily under current law (e.g., Fed officials
(The traditional Taylor rule was not designed to prescribe
who set monetary policy could agree to base their vote on a
unconventional policies, but it does not follow that the
Taylor rule’s prescription). Legislative changes would be
adoption of a Taylor rule would prevent unconventional
needed to require the Fed to adopt these proposals,
policy because, in principle, a new version of the rule could
however. Legislation could provide the specific details on
be designed to base unconventional policies on inflation
what should be incorporated in such a rule or leave it to the
and the output gap.) These issues could be addressed by
Fed to work out the details.
modifying the Taylor rule, but this would arguably reduce
the perceived benefits of a rules-based regime.
Rules Versus Discretion
The desirability of basing policy on a Taylor rule can be
Rules were originally favored by economists who believed
viewed through the prism of the economic debate about the
that Fed discretion was responsible for high inflation, but
superiority of rules versus discretion in policymaking.
inflation has been low since the 1990s. Recently, Taylor
Economists who favor the use of rules argue that policy is
rules have been used to support criticism that the Fed has
more effective if it is predictable and transparent. They
engaged in too much stimulus. Taylor rules in general do
argue that unpredictable policy results in financial and
not inherently have a pro- or anti-stimulus bias, however, as
economic instability. For example, there can be large
their parameters can be adjusted to meet policymakers’
movements in financial prices when the Fed makes a policy
goals. Policymakers who emphasize price stability could
change that “surprises” financial markets. A formal role for
put a relatively high weight on the inflation parameter.
a Taylor rule could also potentially help Congress in its
Alternatively, policymakers who want the Fed to be
oversight capacity by providing a clear benchmark against
responsive to (high or low) growth could put a relatively
which the Fed’s decisions could be evaluated.
high weight on the output gap parameter. Since the form
that a Taylor rule takes involves, in part, value judgments
Economists favoring discretion argue that policymakers
about the goals of monetary policy and the best way to
need flexibility to manage an inherently complex economy
achieve those goals, choosing its form involves political
that is regularly hit by unexpected shocks. For example,
tradeoffs as well as economic modeling.
rules might have hindered the Fed’s ability to respond to the
housing bubble and the financial crisis. In principle, a
CRS Resources
Taylor rule need not be limited to inflation and the output
For an overview, see CRS Report RL30354, Monetary
gap, but making it more complex would reduce the
Policy and the Federal Reserve: Current Policy and
perceived benefits of transparency and predictability.
Conditions, by Marc Labonte.
Likewise, periodically modifying the form that the Taylor
rule takes in response to unforeseen events would reduce
For more information, see CRS Report R42962, Federal
predictability and increases discretion. Further, how could a
Reserve: Unconventional Monetary Policy Options, by
Taylor rule incorporate amorphous concerns about, say,
Marc Labonte.
financial stability or asset bubbles when there is no
consensus on how to quantify them? A Taylor rule requires
Marc Labonte, Specialist in Macroeconomic Policy
data points that are easy to measure and accurately embody
a larger economic phenomenon of concern. Using forecasts
IF10207
would probably be preferable to using actual data in the

Economists who favor rules argue that policy is more
effective if it is predictable and transparent.
Economists favoring discretion argue that
policymakers need flexibility to manage an inherently
complex economy regularly hit by unexpected shocks.
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Monetary Policy and the Taylor Rule

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