The Taylor Rule

The “Taylor rule,” named after the prominent economist John Taylor, is another guide to assessing the proper stance of monetary policy. It relates the setting of the federal funds rate to the primary objectives of monetary policy which is the extent to which inflation may be departing from something approximating price stability and the extent to which output and employment may be departing from their maximum sustainable levels. For example, one version of the rule calls for the federal funds rate to be set equal to the rate thought to be consistent in the long run with the achievement of full employment and price stability plus a component based on the gap between current inflation and the inflation objective less a component based on the shortfall of actual output from the full employment level. If inflation is picking up, the Taylor rule prescribes the amount by which the federal funds rate would need to be raised or, if output and employment are weakening, the amount by which it would need to be lowered. The specific parameters of the formula are set to describe actual monetary policy behavior over a period when policy is thought to have been fairly successful in achieving its basic goals.

Although this guide has appeal, it too has shortcomings. The level of short term interest rates associated with achieving longer term goals, a key element in the formula, can vary over time in unpredictable ways. Moreover, the current rate of inflation and position of the economy in relation to full employment are not known because of data lags and difficulties in estimating the full employment level of output, adding another layer of uncertainty about the appropriate setting of policy.

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