The Taylor Rule A Guidepost for Monetary Policy - Download as PDF by qvu11869


									                                                                                                                                                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
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.
But mere leaning will not be enough                                                           Federal funds target
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
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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