July 2003 Federal Reserve Bank of Cleveland The Taylor Rule: A Guidepost for Monetary Policy? by Charles T. Carlstrom and Timothy S. Fuerst “It seems to me that a reaction function s The Taylor Rule in which the real funds rate changes by There is a long history in economics Once a topic to be found only in schol- roughly equal amounts in response to extolling the virtues of rules. One reason arly economic journals, the Taylor deviations of inflation from a target of 2 is that policymakers, just like individuals, percent and to deviations of actual from rule is popping up regularly in news sometimes need help sticking to a goal potential output describes reasonably that requires long-term commitment. magazines, finance journals, and cen- well what this committee has done since Rules can help policymakers stick to tral bankers’ speeches. Does the Fed 1986. … If we wanted a rule I think the long-term goals when they are tempted follow the rule? Should it? This Com- Greenspan Fed has done very well fol- to deviate from them to gain something mentary explains what the Taylor rule lowing such a rule, and I think that is good in the short run. Pursuing short- is, discusses why it seems to describe what sensible central banks do.” term gain may undermine long-term Fed interest-rate setting, and argues Remarks by then Federal Reserve Governor goals in the same way that rolling over that the rule is most valuable as a Janet Yellen at the January 1995 and hitting the snooze button on the guideline rather than a prescription. FOMC meeting alarm threatens one’s goal of getting to The “rule” Yellen seems to advocate has work on time. But even though rules are become known as the Taylor rule, and it effective, policymakers are understand- The second factor is the “natural” real, or has caught the attention of researchers, ably reluctant to chain themselves to inflation-adjusted, federal funds interest policymakers, and the press. In a semi- ironclad rules. Despite their reluctance, rate. This is the rate that is consistent nal 1993 paper, John Taylor, the current the Taylor rule has had a big impact in with “neutral” monetary policy. That is, undersecretary of Treasury, claimed that monetary policy circles, as well as if the real funds rate is equal to the nat- adhering to a simple rule or strategy economics. Figure 1 suggests why. The ural real rate, then monetary policy will whereby the central bank sets the federal Taylor rule seems to track, very success- be consistent with both the inflation and funds rate in response to two variables— fully, broad policy moves since 1987. output targets. This natural rate undoubt- inflation and deviations from potential This success seems remarkable because edly moves through time. Because of the output—is a useful way to conduct mon- Taylor’s rule is so simple: It is set accord- difficulty of measuring it, however, etary policy. He maintained that such a ing to only four components. Taylor assumed that the natural real rate rule could keep inflation low and stable The first factor is the Fed’s long-term is constant at 2 percent. He picked this without the “go–stop” fluctuations in inflation target. This is the inflation rate number because it is approximately the output that had plagued the economy that will prevail on average over time average real interest rate over a long-time during the 1970s. Taylor went further although the actual inflation rate will horizon. In more complicated rules one and claimed that the actual policy moves differ, sometimes significantly, from this can potentially incorporate this rate mov- made by the FOMC since 1987 are well target at any point in time. While Taylor ing around as shocks hit the economy. characterized by such a rule. claimed that a 2 percent inflation target The sum of the first two factors, the nat- Clearly, the FOMC considers a myriad is preferred to 5 percent, there is no ural real rate and the Fed’s long-term of data when making decisions. Yet agreement on whether it should be 2, 0, inflation target, determine the long-run many agree that a simple rule like the or, for that matter, –1 percent. Taylor (nominal) federal funds rate. In Taylor’s one Taylor described does approximate simply assumed a long-run inflation original rule this amounted to four per- the FOMC’s actual policy moves over target of 2 percent (the average inflation cent per year. The two remaining factors the past 15 years. In what sense is this rate since 1985 has been 2.6 percent). It address the way policy should respond true? This Economic Commentary should be kept in mind, however, that in the short run to changing circum- explains what the Taylor rule is, dis- there is nothing magical about 2 percent stances, namely, to changes in output cusses how well it predicts the actual inflation, and the rule can be modified and inflation. These third and fourth federal funds rate, and perhaps gives for a different inflation target. components of the Taylor rule are the some insight into why it has sparked current rates of inflation and output. so much interest. ISSN 0428-1276 s Output and Inflation FIGURE 1 TAYLOR RULE VERSUS Stabilization FEDERAL FUNDS TARGET RATE The Taylor rule prescribes that the Fed “lean against the wind” when setting Percent 11 interest rates; that is, that it raise interest rates when current output rises higher 10 than potential. The rule also prescribes a similar response to inflation—raise 9 interest rates when the inflation rate over the past year is higher than its 8 long-term target. 7 But mere leaning will not be enough Federal funds target 6 when it comes to inflation. Taylor cau- tioned that interest rates must rise by 5 more than the increase in inflation. Given that nominal interest rates natu- 4 rally increase one for one with move- Taylor rule a ments in anticipated inflation, just 3 increasing the funds rate one for one with inflation is like treading water. 2 Therefore, the Fed must increase the 1 real funds rate with inflation to make any headway in reducing inflation. This 0 more-than-proportional response of the 1987 1988 1989 1990 1991 1992 1993 1994 1995 1996 1997 1998 1999 2000 2001 2002 2003 nominal funds rate to inflation is known SOURCES: Board of Governors of the Federal Reserve System. “Selected Interest Rates, “Federal Reserve Sta- as the Taylor principle. The Taylor tistical Releases, H. 15; the Congressional Budget Office; and the Bureau of Economic Analysis. principle prescribes that the real federal a. Inflation is measured from the Personal Consumption Expenditures Chain Type Price Index, 4-quarter funds rate should be made greater than change. The output gap is calculated as the percent deviation of potential GDP from real GDP as measured by the Congressional Budget Office and the Bureau of Economic Analysis, respectively. the natural rate of interest whenever inflation is above target. In the simplest form of the rule (which performance since 1993—the date Taylor Not following the Taylor principle may was used in figure 1), Taylor argued that first proposed it. Because the rule was open the economy up to inflationary the Fed should increase the real funds defined with the benefit of pre-1993 data, spirals. Increases in inflation would rate by one-half a percentage point for it can’t help but describe those periods reduce real interest rates, which would every percentage point deviation that well, these critics might argue. But if the then further increase inflation. Of inflation is above target or that output is rule captures the real determinants of Fed course, the same logic works in reverse. above potential. (Likewise, the Fed decisionmaking, it should also describe The end result is that inflation has no should decrease the real funds rate by the the Fed’s behavior “out of sample,” that anchor that would pull it to its long-run same amount for deviations below target is, for a period whose data wasn’t used target. In a very real sense then, mone- or potential.) Thus, Taylor felt that mon- when calculating the original rule. Yet tary policy has no long-run target. While etary policy (in terms of the real funds after 1993 the funds rate has usually devi- such spirals seem like fantasy, some rate) should respond equally to inflation ated substantially from the Taylor target. economists have suggested that one and output deviations. While the Taylor reason inflation got out of control dur- These misses, however, do not distract rule, of course, satisfies the Taylor prin- ing the 1970s is because the Fed did not proponents of the Taylor rule. They ciple, there are many other rules or react aggressively enough to inflation. argue that the rule was never meant to policies that also satisfy this principle. Conversely, there are Taylor-type rules be followed rigidly. In fact, the term For a given level of the nominal funds (in which the nominal funds rate Taylor “rule” is a misnomer. Taylor rate, the real funds rate will tend over responds to inflation and output) that do actually proposed it not so much as a time to equal the natural real rate of not satisfy the Taylor principle. mechanical rule but instead as a guide- interest. But in the short run, these two post for monetary policy. With guide- need not be equal. If the real funds rate s Is Recent Monetary Policy posts, deviations from the prescribed is held lower than the natural rate of Consistent with the Taylor “rule” and, at times, even substantial interest, the money supply will increase, Rule? ones, are permitted. The idea of using thus pushing down the real funds rate While the Taylor rule clearly tracks broad the rule as a guidepost as opposed to below the natural rate. Inflation and out- movements in the funds rate, just as having absolute discretion, however, is put will also tend to be higher when the clearly, it produces large and persistent that it obligates policymakers to provide real funds rate is lower than the natural misses (see figure 1). Critics of the rule’s a compelling argument for why they real rate of interest. By how much usefulness suggest that judging how well have allowed the deviations. Taylor rec- should the Fed change the real funds the Taylor rule describes actual fed policy ognized that special factors will always rate in response to changes in output requires that we look primarily at its occur that will (and should) cause the and inflation? Fed to deviate substantially from the impossible to test this hypothesis by The Taylor rule should not be thought course prescribed by any rule. Follow- looking at the past. A second possibility of as a strict policy prescription, but ing the Taylor rule therefore does not is the latent sense of insecurity linked instead as a guideline or rule of thumb require that the funds rate respond only to the 9/11 attacks and the military for monetary policy. Following a rule to changes in inflation and the output interventions in the Middle East. Sup- rigidly has obvious drawbacks. But gap, but instead requires that these are porters of the Taylor rule would just adhering to a rule generally, so long as the only variables the central bank argue that once these special circum- it satisfies the Taylor principle over the should consistently and systematically stances are over, policymakers will long run, provides hard-won credibility respond to. increase the funds rate to once again be that allows for periodic deviations from in line with the rule. the rule with no loss of control over For example, the funds rate was consis- inflation. tently above the Taylor rule target s Guideposts and Credibility through the latter half of the 1990s. Yet We have focused on the Taylor rule as s Recommended Reading the rule’s proponents argue that produc- one potential guidepost for monetary Ben S. Bernanke, 2003, “’Constrained tivity growth increased in 1995, and policy. There are many others. It is Discretion and Monetary Policy,” this was translating into faster eco- important to recognize that this rule can Remarks before the Money Marketers nomic growth. Faster economic growth, easily be adjusted to accommodate of New York University, New York, they argue, manifests itself in higher inflation targets other than the 2 percent N.Y., February 3. real rates of interest and thus a higher level suggested by Taylor or structural natural real interest rate. While Taylor changes in the economy that affect the The Economist, 1996, “Monetary treated this factor as a constant, policy- natural real federal funds rate. Since Policy Made to Measure,” August 10. makers who believed higher productiv- Taylor suggested his original rule, con- Edward M. Gramlich, 1998, “Monetary ity was here to stay (because computers siderable work has been done on Rules,” The Samuelson Lecture, had created a “New Economy”) would whether central banks should respond Remarks before the 24th Annual Con- have adjusted the Taylor rule up more, or less, aggressively to inflation ference of the Eastern Economic Asso- accordingly. Even if the fed funds rate or the output gap. ciation, New York, N.Y., February 27. deviated from the rate prescribed by the Taylor rule during this period, many This work suggests that the exact form Laurence H. Meyer, 2002, “Rules and claim policy decisions did not necessar- of the Taylor rule is probably not that Discretion,” Remarks at the Owen ily deviate from the spirit of the rule. important. What is important, however, Graduate School of Management, That is, monetary policy may have fol- is that potential guideposts satisfy the Vanderbilt University, Nashville, lowed a Taylor rule in which the natural Taylor principle. That is, the nominal Tenn., January 16. rate of interest was not simply assumed interest rate must increase more than one to be constant. Instead, it was estimated for one with increases in inflation. Along Lars E.O. Svensson, 2003, “What Is based on economic theory. with reliable guideposts that satisfy the Wrong with Taylor Rules? Using Taylor principle comes credibility. Judgment in Monetary Policy through Similarly, several unique circumstances Targeting Rules,” Journal of Economic may explain why monetary policy has Credibility gives the central bank the Literature, (June, forthcoming). recently been “easier” than would be latitude to temporarily deviate from any predicted by the Taylor rule (that is, the guidepost without risking the possibility John B. Taylor, 1993, “Discretion ver- fed funds interest rate has been lower). of reigniting inflation. Indeed, credibility sus Policy Rules in Practice,” One possibility is the remarkable implies that policy can even deviate Carnegie-Rochester Conference Series decline of equity prices over the last from the Taylor principle for short peri- on Public Policy 39, pp. 195–214. 12 months. This large and sustained ods of time. Guideposts provide the pre- decline is without parallel during dictability and credibility of firm rules Greenspan’s tenure, which makes it without making it impossible or very difficult to respond to unforeseen events. Charles T. Carlstrom is a senior economic advisor at the Federal Reserve Bank of Cleveland, and Timothy S. Fuerst is the Owens Illinois Professor at Bowling Green State University and a research associate at the Bank. The views expressed here are those of the authors and not necessarily those of the Fed- eral Reserve Bank of Cleveland, the Board of Governors of the Federal Reserve System, or its staff. 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