# Understanding the Taylor Rule: A Guide for Central Bank Policy

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*— Investopedia / Julie Bang*

## What Is the Taylor Rule?

The Taylor Rule is an influential formula developed by economist John Taylor that has shaped monetary policy strategy by linking interest rates to inflation and economic growth targets. This guideline is crucial for central banks aiming to stabilize economies, though it has been met with debates over its application and limitations, especially during times of economic instability.  

### Key Takeaways

*   The Taylor Rule is a formula that links a central bank's policy rate to inflation and economic growth, aiming to stabilize the economy.  
    
*   Developed by economist John Taylor in 1993, it assumes an equilibrium federal funds rate of 2% above the annual inflation rate.
*   The formula adjusts the rate based on the difference between actual and targeted inflation and real GDP growth, emphasizing inflation.
*   The Taylor Rule does not consider alternative monetary tools like quantitative easing or the challenges posed by negative interest rates.
*   Although useful, the rule oversimplifies real-world complexities and doesn't account for the Federal Reserve's dual mandate of stable prices and maximum employment.

## How the Taylor Rule Functions in Monetary Policy

When Taylor introduced the Taylor Rule formula, he noted it accurately reflected [Federal Reserve policy](https://www.investopedia.com/ask/answers/111314/what-methods-can-government-use-control-inflation.asp) during several years leading up to 1993, but also described it as a "concept...in a policy environment where it is practically impossible to follow mechanically any particular algebraic formula that describes the policy rule."

The rule suggests a higher [federal funds rate](https://www.investopedia.com/terms/f/federalfundsrate.asp) when inflation is above target and a lower rate if inflation is below target. Similarly, real GDP growth above a target (typically defined by the economy's full potential) would dictate a higher interest rate, while growth short of the mark would serve to lower it.

## Breaking Down the Taylor Rule Equation

In its simplest form, Taylor's equation is: r = p + 0.5y + 0.5(p - 2) + 2  

_r = p + 0.5y + 0.5(p - 2) + 2_

Where:

*   _r_ = nominal fed funds rate
*   _p_ = the rate of inflation
*   y = the percent deviation between the current real GDP and the long-term linear trend in GDP 

The equation assumes the equilibrium federal funds rate of 2% above inflation, represented by the sum of _p_ (inflation rate) and the "2" on the far right.

From that equilibrium, the federal funds rate is assumed to move up or down by half the difference between actual and targeted inflation, with overshoots relative to the target increasing the rate and undershoots lowering it.

The other variable is the output gap or the difference between [actual and targeted growth in real GDP](https://www.investopedia.com/terms/g/gdpgap.asp). As with inflation, each percentage point of the output gap moves the expected federal funds rate by half a percentage point, with growth above target raising it and shortfalls lowering it.

## Exploring Taylor Rule Limitations and Critiques

The Taylor Rule is often a good guide for monetary policy during stable times of growth and moderate inflation but is less effective during economic crises. For instance, the Taylor Rule and its derivatives prescribed a sharply negative federal funds rate during the short, deep recession caused by the COVID-19 pandemic, while in practical terms the fed funds rate is constrained by the [zero bound](https://www.investopedia.com/terms/z/zero-bound-interest-rate.asp), the Federal Reserve noted in its June 2022 monetary policy report to Congress.

Because monetary policy becomes ineffective at [negative interest rates](https://www.investopedia.com/terms/n/negative-interest-rate.asp), central banks have responded to severe economic crises with alternative tools including large-scale asset purchases, also known as [quantitative easing](https://www.investopedia.com/terms/q/quantitative-easing.asp). According to the Fed, the basic Taylor Rule doesn't account for these policy tools. Nor does it apply risk management principles, treating the output gap and the inflation rate as predictable and their divergences from targets as equally important.

During economic stress, these measures can fluctuate widely, complicating policymakers' assessments of a sustainable path. Few faulted the Fed for focusing on downside risks at the depths of the COVID-19 panic, while the Taylor Rule will always treat recent inflation as an equally important consideration regardless of circumstances.

Former Federal Reserve Chairman Ben Bernanke used similar arguments in responding to Taylor's criticisms of the Fed's monetary policy before and after the 2007-2009 global financial crisis. Given the limitations of the Taylor Rule formula, "I don’t think we’ll be replacing the [FOMC](https://www.investopedia.com/terms/f/fomc.asp) with robots anytime soon," Bernanke concluded.

## Variations in Taylor Rule Interpretations

By assuming a short-term interest rate that is 2% above inflation, the Taylor Rule prioritizes inflation as the most important factor. While Federal Reserve vice chair, [Janet Yellen](https://www.investopedia.com/articles/investing/101613/janet-yellen-background-and-philosophy.asp) referenced a modified Taylor Rule giving equal weight to deviations from the Fed's inflation and growth targets, while noting that it would still have prescribed suboptimally tight monetary policy.

The Federal Reserve's monetary policy report in June 2022 presented a version of such a "balanced-approach" rule, along with an alternative modification of the Taylor Rule delaying the prescribed increases in rates to offset cumulative shortfall in policy accommodation as a result of the effective lower bound limit.

Bernanke has written that the Fed is more likely to trust a Taylor Rule formula doubling the weighting of the output gap factor relative to inflation as most consistent with its dual mandate to promote stable prices and maximum employment.

The Federal Reserve's versions of the Taylor Rule also replace the output gap with the difference between the long-run unemployment rate and current unemployment, in keeping with the employment part of the Fed's mandate. The Federal Reserve focuses on the [Personal Consumption Expenditures (PCE)](https://www.investopedia.com/terms/p/pce.asp) Price Index as its preferred measure of inflation.

## Concluding Thoughts on the Taylor Rule

The Taylor Rule provides a structured framework for setting interest rates but overlooks the Federal Reserve's dual mandate to promote stable prices and maximum employment. It assumes a fixed-rule policy that may not effectively adapt to the unpredictability of real-world economic conditions. While it offers guidance during stable periods, the Taylor Rule can fall short during economic crises or when employing alternative monetary tools like quantitative easing. John Taylor himself acknowledged the limitations, noting that policy adjustments are necessary in response to unique economic circumstances. Readers should consider these factors when evaluating or discussing the applicability of the Taylor Rule.

> **Article Sources**
>
> 1.  Taylor, John B. "[Discretion Versus Policy Rules in Practice](https://web.stanford.edu/~johntayl/Onlinepaperscombinedbyyear/1993/Discretion_versus_Policy_Rules_in_Practice.pdf)." _Carnegie-Rochester Conference Series on Public Policy_, vol. 39, 1993, Page 195.
>     
> 2.  The Brookings Institution. "[The Taylor Rule: A Benchmark for Monetary Policy?](https://www.brookings.edu/blog/ben-bernanke/2015/04/28/the-taylor-rule-a-benchmark-for-monetary-policy/)"
>     
> 3.  Board of Governors of the Federal Reserve System. "[Monetary Policy Report, June 17, 2022](https://www.federalreserve.gov/monetarypolicy/files/20220617_mprfullreport.pdf)," Pages 46-48.
>     
> 4.  Board of Governors of the Federal Reserve System. "[Monetary Policy Report, June 17, 2022](https://www.federalreserve.gov/monetarypolicy/files/20220617_mprfullreport.pdf)," Page 48.
>     
> 5.  Board of Governors of the Federal Reserve System. "[Revolution and Evolution in Central Bank Communications](https://www.federalreserve.gov/newsevents/speech/yellen20121113a.htm)."
>     
> 6.  Board of Governors of the Federal Reserve System. "[Monetary Policy Report, June 17, 2022](https://www.federalreserve.gov/monetarypolicy/files/20220617_mprfullreport.pdf)," Pages 1, 46.
>     
> 7.  Taylor, John B. "[Discretion Versus Policy Rules in Practice](https://web.stanford.edu/~johntayl/Onlinepaperscombinedbyyear/1993/Discretion_versus_Policy_Rules_in_Practice.pdf)." _Carnegie-Rochester Conference Series on Public Policy_, vol. 39, 1993, Pages 196-197.