View source for Taylor rule

{{short description|Rule from monetary policy}}
{{Distinguish|Taylor Law|Taylor's law|Taylor's theorem}}
The '''Taylor rule''' is a [[monetary policy]] targeting rule. The rule was proposed in 1992 by American economist [[John B. Taylor]]<ref>{{Cite web|title=Interview with John B. Taylor {{!}} Federal Reserve Bank of Minneapolis|url=https://www.minneapolisfed.org:443/article/2006/interview-with-john-b-taylor|date=March 8, 2006|editor-last=Clement|editor-first=Douglas|website=www.minneapolisfed.org|language=en|access-date=2020-05-22}}</ref> for [[central bank]]s to use to stabilize economic activity by appropriately setting short-term [[interest rate]]s.<ref>{{Citation |last1=Judd |first1=John P. |title=Has the Fed Gotten Tougher on Inflation? |date=2020-04-30 |url=http://dx.doi.org/10.4324/9780429270949-48 |work=Handbook of Monetary Policy |pages=635–639 |publisher=Routledge |access-date=2022-11-24 |last2=Trehan |first2=Bharat|doi=10.4324/9780429270949-48 |isbn=9780429270949 |s2cid=154075608 }}</ref> The rule considers the [[federal funds rate]], the [[price level]] and changes in [[real income]].<ref name="John B. Taylor 1993">John B. Taylor, Discretion versus policy rules in practice (1993), Stanford University, y, Stanford, CA 94905</ref> The Taylor rule computes the optimal [[federal funds rate]] based on the gap between the desired (targeted) [[inflation rate]] and the actual inflation rate; and the [[output gap]] between the actual and natural output level. According to Taylor, monetary policy is stabilizing when the [[nominal interest rate]] is higher/lower than the increase/decrease in [[inflation]].<ref name="ReferenceA">{{Cite report |last=Mishkin |first=Frederic |date=February 2011 |title=Monetary Policy Strategy: Lessons from the Crisis |doi=10.3386/w16755 |website=National Bureau of Economic Research|doi-access=free }}</ref> Thus the Taylor rule prescribes a relatively high interest rate when actual inflation is higher than the inflation target.

In the [[United States]], the [[Federal Open Market Committee]] controls monetary policy. The committee attempts to achieve an average inflation rate of 2% (with an equal likelihood of higher or lower inflation). The main advantage of a general targeting rule is that a central bank gains the discretion to apply multiple means to achieve the set target.<ref name="Lars E. O 2003">{{Cite report |last=Svensson |first=Lars E. O.|date=January 2003 |title=What is Wrong with Taylor Rules? Using Judgment in Monetary Policy through Targeting Rules |doi=10.3386/w9421 |website=National Bureau of Economic Research|doi-access=free }}</ref>

The monetary policy of the [[Federal Reserve]] changed throughout the 20th century. Taylor and others evaluate the period between the 1960s and the 1970s as a period of poor monetary policy; the later years are typically characterized as [[stagflation]]. The inflation rate was high and increasing, while interest rates were kept low.<ref>{{Cite web |title=Causes of the Financial Crisis and the Slow Recovery: A 10-Year Perspective {{!}} Stanford Institute for Economic Policy Research (SIEPR) |url=https://siepr.stanford.edu/publications/working-paper/causes-financial-crisis-and-slow-recovery-10-year-perspective |access-date=2022-11-24 |website=siepr.stanford.edu |language=en|last=Taylor|first= John B. |date=January 2014|publisher=Hoover Institution Economics Working Paper}}</ref> Since the mid-1970s monetary targets have been used in many countries as a means to target inflation.<ref name="Pier Francesco Asso 2010">{{Cite journal |last1=Asso |first1=Pier Francesco |last2=Kahn |first2=George A. |last3=Leeson |first3=Robert |date=2010 |title=The Taylor Rule and the Practice of Central Banking |journal=SSRN Electronic Journal |doi=10.2139/ssrn.1553978 |issn=1556-5068|publisher=The Federal Reserve Bank of Kansas City|s2cid=153150134 }}</ref> However, in the 2000s the actual interest rate in [[Developed country|advanced economies]], notably in the US, was kept below the value suggested by the Taylor rule.<ref name="Boris Hofmann 2012">{{Cite book |first=Boris |last=Hofmann |title=Taylor Rules and Monetary Policy A Global 'Great Deviation'? |oclc=1310400578|year= 2012}}</ref> 

The [[Taylor rule]] represents a rules-based approach to monetary policy, standing in contrast to discretionary policy where central bankers make decisions based on their judgment and interpretation of economic conditions. While the rule provides a systematic framework that can enhance policy predictability and transparency, critics argue that its simplified formula—focusing primarily on inflation and output—may not adequately capture important factors such as financial stability, exchange rates, or structural changes in the economy. This debate between rules and discretion remains central to discussions of monetary policy implementation.

==Equation==
According to Taylor's original version of the rule, the [[real interest rate|real]] policy interest rate should respond to divergences of actual inflation rates  from target inflation rates and of actual [[Gross Domestic Product]] (GDP) from potential GDP:

:<math>i_t = \pi_t + r_t^* + a_\pi  ( \pi_t - \pi_t^* )  + a_y \cdot 100 ( Y_t - \bar Y_t )/ \bar Y_t.</math>

In this equation, <math>\,i_t\,</math> is the target short-term [[nominal interest rate|nominal]] policy interest rate (e.g. the [[federal funds rate]] in the US, the [[Official bank rate|Bank of England base rate]] in the UK), <math>\,\pi_t\,</math> is the rate of [[inflation]] as measured by the [[GDP deflator]], <math>\pi^*_t</math> is the desired rate of inflation, <math>r_t^*</math> is the assumed natural/equilibrium interest rate,<ref>{{Cite periodical |last1=Lopez-Salido |first1=David |last2=Sanz-Maldonado |first2=Gerardo |last3=Schippits |first3=Carly |last4=Wei |first4=Min |date=2020-06-19 |title=Measuring the Natural Rate of Interest: The Role of Inflation Expectations |periodical=FEDS Notes |url=https://www.federalreserve.gov/econres/notes/feds-notes/measuring-the-natural-rate-of-interest-the-role-of-inflation-expectations-20200619.html |language=en}}</ref> <math>\,Y_t\,</math> is the actual [[Gross Domestic Product|GDP]], and <math>\bar Y_t</math> is the [[potential output]], as determined by a linear trend. <math>100(Y_t - \bar Y_t)/ \bar Y_t</math> is the [[output gap]], in percentage points.

Because of <math>i_t - \pi_t = \mbox{real policy interest rate}</math>,
: <math>\begin{align}
  \mbox{Desired real policy interest rate} &= \mbox{equilibrium real interest rate} \\
  &+ a_{\pi} \times \mbox{difference from the inflation target} \\
  &+ a_y \times \mbox{output gap} \\
  \end{align}
</math>
In this equation, both <math>a_{\pi}</math> and <math>a_y</math> should be positive (as a rough rule of thumb, Taylor's 1993 paper proposed setting <math>a_{\pi}=a_y=0.5</math>).<ref>{{cite book|first=Athanasios |last=Orphanides |year=2008|chapter=Taylor rules equation (7)|title=[[The New Palgrave Dictionary of Economics]] |edition=2|volume= 8 |pages=2000–2004 |chapter-url=http://www.dictionaryofeconomics.com/article?id=pde2008_T000215&q=taylor%20rules&topicid=&result_number=1 }}{{dead link|date=November 2022}}</ref>  That is, the rule produces a relatively high real interest rate (a "tight" monetary policy) when inflation is above its target or when output is above its [[full employment|full-employment]] level, in order to reduce inflationary pressure.  It recommends a relatively low real interest rate ("easy" monetary policy) in the opposite situation, to stimulate output.  Sometimes monetary policy goals may conflict, as in the case of stagflation, when inflation is above its target with a substantial output gap. In such a situation, a Taylor rule specifies the relative weights given to reducing inflation versus increasing output.

==Principle==
By specifying <math>a_{\pi}>0</math>, the Taylor rule says that an increase in inflation by one percentage point should prompt the [[central bank]] to raise the [[nominal interest rate]] by more than one percentage point (specifically, by <math>1+a_{\pi}</math>, the sum of the two coefficients on <math>\pi_t</math> in the equation). Since the [[real interest rate]] is (approximately) the nominal interest rate minus inflation, stipulating <math>a_{\pi}>0</math> implies that when inflation rises, the [[real interest rate]] should be increased.  The idea that the nominal interest rate should be raised "more than one-for-one" to cool the economy when inflation increases (that is increasing the real interest rate) has been called the Taylor principle. The Taylor principle presumes a unique bounded [[Economic equilibrium|equilibrium]] for inflation. If the Taylor principle is violated, then the inflation path may be unstable.<ref>{{cite journal |title=Generalizing the Taylor Principle |first1=Troy |last1=Davig |first2=Eric M. |last2=Leeper |journal=[[American Economic Review]] |volume=97 |issue=3 |year=2007 |pages=607–635 |jstor=30035014 |doi=10.1257/aer.97.3.607|url=https://caepr.indiana.edu/RePEc/inu/caeprp/CAEPR2006-001.pdf }}</ref>

== History ==
The concept of a policy rule emerged as part of the discussion on whether monetary policy should be based on intuition/discretion. The discourse began at the beginning of the 19th century. The first formal debate forum was launched in the 1920s by the US House Committee on Banking and Currency. In the hearing on the so-called Strong bill, introduced in 1923 by Representative [[James G. Strong]] of Kansas, the conflict in the views on monetary policy clearly appeared. New York Fed Governor [[Benjamin Strong Jr.]] (no relation to Representative Strong), supported by Professors [[John R. Commons]] and [[Irving Fisher]], was concerned about the Fed's practices that attempted to ensure price stability. In his opinion, Federal Reserve policy regarding the price level could not guarantee long-term stability. After the death of Governor Strong in 1928, political debate on changing the Fed's policy was suspended. The Fed had been dominated by Strong and his [[Federal Reserve Bank of New York|New York Reserve Bank]].

After the [[Great Depression]] hit the country, policies came under debate. [[Irving Fisher]] opined, "this depression was almost wholly preventable and that it would have been prevented if Governor Strong had lived, who was conducting open-market operations with a view of bringing about stability".<ref>{{Cite web |last=Hetzel |first=Robert L. |date=1985 |title=The Rules versus Discretion Debate Over Monetary Policy in the 1920s |website=Federal Reserve Bank of Richmond |url=https://www.richmondfed.org/~/media/richmondfedorg/publications/research/economic_review/1985/pdf/er710601.pdf|language=en }}</ref> Later on, monetarists such as [[Milton Friedman]] and [[Anna Schwartz]] agreed that high inflation could be avoided if the Fed managed the quantity of money more consistently.<ref name="ReferenceA"/>

The economic downturn of the early 1960s in the United States occurred despite the Federal Reserve maintaining relatively high interest rates to defend the dollar under the [[Bretton Woods system]]. After the collapse of Bretton Woods in 1971, the Federal Reserve shifted its focus toward stimulating economic growth through expansionary monetary policy and lower interest rates. This accommodative policy stance, combined with supply shocks from oil price increases, contributed to the Great Inflation of the 1970s when annual inflation rates reached double digits.

Beginning in the mid-1970s, central banks increasingly adopted monetary targeting frameworks to combat inflation. During the [[Great Moderation]] from the mid-1980s through the early 2000s, major central banks including the Federal Reserve and the Bank of England generally followed policy approaches aligned with the Taylor rule, which provided a systematic framework for setting interest rates. This period was marked by low and stable inflation in most advanced economies. A significant shift in monetary policy frameworks began in 1990 when New Zealand pioneered explicit inflation targeting. The [[Reserve Bank of New Zealand]] underwent reforms that enhanced its independence and established price stability as its primary mandate. This approach was soon adopted by other central banks: the [[Bank of Canada]] implemented inflation targeting in 1991, followed by the central banks of Sweden, Finland, Australia, Spain, Israel, and Chile by 1994.<ref name="Pier Francesco Asso 2010"/>

From the early 2000s onward, major central banks in advanced economies, particularly the Federal Reserve, maintained policy rates consistently below levels prescribed by the Taylor rule. This deviation reflected a new policy framework where central banks increasingly focused on financial stability while still operating under inflation-targeting mandates. Central banks adopted an asymmetric approach: they responded aggressively to financial market stress and economic downturns with substantial rate cuts, but were more gradual in raising rates during recoveries. This pattern became especially pronounced following shocks like the dot-com bubble burst, the 2008 financial crisis, and subsequent economic disruptions, leading to extended periods of accommodative monetary policy.<ref name="Boris Hofmann 2012"/>

==Alternative versions==
[[File:Taylor Rule Prescriptions for Fed Funds Rate 2016.png|thumb|350px|right|Effective federal funds rate and prescriptions from alternate versions of the Taylor Rule]]
While the Taylor principle has proven influential, debate remains about what else the rule should incorporate. According to some [[New Keynesian economics|New Keynesian]] macroeconomic models, insofar as the central bank keeps inflation stable, the degree of fluctuation in output will be optimized (economists [[Olivier Blanchard]] and [[Jordi Gali]] call this property the '[[divine coincidence]]'). In this case, the central bank does not need to take fluctuations in the output gap into account when setting interest rates (that is, it may optimally set <math>a_y=0</math>.)

Other economists proposed adding terms to the Taylor rule to take into account financial conditions: for example, the interest rate might be raised when stock prices, housing prices, or interest rate spreads increase. Taylor offered a modified rule in 1999: that specified <math>a_{\pi} = 0.5, a_y \ge 0</math>.

== Alternative theories ==
The solvency rule was presented by Emiliano Brancaccio after the 2008 financial crisis. The banker follows a rule aimed at controlling the economy's solvency .<ref>{{Cite book |title=The global economic crisis: new perspectives on the critique of economic theory and policy |date=2011 |publisher=Routledge |editor=Emiliano Brancaccio |editor2=Giuseppe Fontana |isbn=978-0-203-81672-1 |location=Abingdon, Oxon |oclc=786002088}}</ref> The inflation target and output gap are neglected, while the interest rate is conditional upon the solvency of workers and firms. The solvency rule was presented more as a benchmark than a mechanistic formula.<ref name=solvency>{{Cite journal |last1=Brancaccio |first1=Emiliano |last2=Fontana |first2=Giuseppe |date=2013 |title='Solvency rule' versus 'Taylor rule': an alternative interpretation of the relation between monetary policy and the economic crisis |url=https://www.jstor.org/stable/23601922 |journal=Cambridge Journal of Economics |volume=37 |issue=1 |pages=17–33 |doi=10.1093/cje/bes028 |jstor=23601922 |issn=0309-166X}}</ref><ref>{{Cite journal |last1=Brancaccio |first1=Emiliano |last2=Califano |first2=Andrea |last3=Lopreite |first3=Milena |last4=Moneta |first4=Alessio |date=2020-06-01 |title=Nonperforming loans and competing rules of monetary policy: A statistical identification approach |url=https://www.sciencedirect.com/science/article/pii/S0954349X19304874 |journal=Structural Change and Economic Dynamics |language=en |volume=53 |pages=127–136 |doi=10.1016/j.strueco.2020.02.001 |hdl=11382/533350 |s2cid=214323300 |issn=0954-349X|hdl-access=free }}</ref>

The [[McCallum rule]] was offered by economist [[Bennett T. McCallum]] at the end of the 20th century. It targets the [[Gross domestic product|nominal gross domestic product]]. He proposed that the Fed stabilize nominal GDP. The McCallum rule uses precise financial data.<ref>{{Cite report |last1=Gallmeyer |first1=Michael |last2=Hollifield |first2=Burton |last3=Zin |first3=Stanley |date=April 2005 |title=Taylor Rules, McCallum Rules and the Term Structure of Interest Rates |doi=10.3386/w11276 |website=National Bureau of Economic Research|doi-access=free }}</ref> Thus, it can overcome the problem of unobservable variables.

[[Market monetarism]] extended the idea of NGDP targeting to include level targeting (targeting a specific amount of growth per time period, and accelerating/decelerating growth to compensate for prior periods of weakness/strength). It also introduced the concept of targeting the forecast, such that policy is set to achieve the goal rather than merely to lean in one direction or the other. One proposed mechanism for assessing the impact of policy was to establish an NGDP [[futures market]] and use it to draw upon the insights of that market to direct policy.

==Empirical relevance==
Although the [[Federal Reserve]] does not follow the Taylor rule,<ref>{{cite journal |doi=10.1016/j.iref.2019.01.010 |title=Central bank losses and monetary policy rules: A DSGE investigation |journal=International Review of Economics & Finance |volume=61 |pages=289–303 |year=2019 |last1=Benchimol |first1=Jonathan |last2=Fourçans |first2=André |s2cid=159290669 |url=https://ideas.repec.org/a/eee/reveco/v61y2019icp289-303.html }}</ref> many analysts have argued that it provides a fairly accurate explanation of US monetary policy under [[Paul Volcker]] and [[Alan Greenspan]]<ref name="Clarida 2000">{{cite journal |last1=Clarida |first1=Richard |first2=Jordi |last2=Galí |first3=Mark |last3=Gertler |year=2000 |title=Monetary Policy Rules and Macroeconomic Stability: Theory and Some Evidence |journal=[[Quarterly Journal of Economics]] |volume=115 |issue=1 |pages=147–180 |doi=10.1162/003355300554692 |jstor=2586937 |citeseerx=10.1.1.111.7984 |s2cid=5448436 }}</ref><ref>{{Cite news |last=Lowenstein |first=Roger |title=The Education of Ben Bernanke | newspaper=The New York Times |date=2008-01-20 |url=https://www.nytimes.com/2008/01/20/magazine/20Ben-Bernanke-t.html}}</ref> and other developed economies.<ref>{{cite journal |last1=Bernanke |first1=Ben |first2=Ilian |last2=Mihov |year=1997 |title=What Does the Bundesbank Target? |journal=[[European Economic Review]] |volume=41 |issue=6 |pages=1025–1053 |doi=10.1016/S0014-2921(96)00056-6 |s2cid=154187980 |url=http://www.nber.org/papers/w5764.pdf }}</ref><ref>{{cite journal |last1=Clarida |first1=Richard |first2=Mark |last2=Gertler |first3=Jordi |last3=Galí |year=1998 |title=Monetary Policy Rules in Practice: Some International Evidence |journal=European Economic Review |volume=42 |issue=6 |pages=1033–1067 |doi=10.1016/S0014-2921(98)00016-6 |s2cid=158171496 |url=http://papers.nber.org/papers/w6254.pdf }}</ref> This observation has been cited by [[Richard Clarida|Clarida]], [[Jordi Galí|Galí]], and [[Mark Gertler (economist)|Gertler]] as a reason why inflation had remained under control and the economy had been relatively stable in most developed countries from the 1980s through the 2000s.<ref name="Clarida 2000" /> However, according to Taylor, the rule was not followed in part of the 2000s, possibly inflating the housing bubble.<ref>{{cite web |url=http://www.stanford.edu/~johntayl/FCPR.pdf |title=The Financial Crisis and the Policy Responses: An Empirical Analysis of What Went Wrong |first=John B. |last=Taylor |year=2008 }}</ref><ref>{{cite book |last=Taylor |first=John B. |year=2009 |title=Getting Off Track: How Government Actions and Interventions Caused, Prolonged, and Worsened the Financial Crisis |publisher=Hoover Institution Press |isbn=978-0-8179-4971-6 |url-access=registration |url=https://archive.org/details/gettingofftrackh00tayl }}</ref> Some research has reported that households form expectations about the future path of interest rates, inflation, and unemployment in a way that is consistent with Taylor-type rules.<ref>{{cite journal |journal=Federal Reserve Bank of San Francisco Working Paper 2012-01 |title=Do People Understand Monetary Policy? |first1=Carlos |last1=Carvalho |first2=Fernanda |last2=Nechio |year=2013 |ssrn=1984321 }}</ref> Other show that monetary policy rule estimations may differ under limited information, involving different considerations in terms of central bank objectives and on the monetary policy rule types.<ref>{{cite journal |doi=10.1016/j.jmacro.2024.103604 |title=Central bank objectives, monetary policy rules, and limited information |journal=Journal of Macroeconomics |volume=80 |number=103604 |year=2024 |last1=Benchimol |first1=Jonathan |url=https://ideas.repec.org/a/eee/jmacro/v80y2024ics0164070424000193.html }}</ref>

== Limitations ==
The Taylor rule is debated in the discourse of the rules vs. discretion. Limitations of the Taylor rule include.

* The 4-month period typically used is not accurate for tracking price changes and is too long for setting interest rates.<ref>{{Cite journal |last=Taylor |first=John B. |date=1993-12-01 |title=Discretion versus policy rules in practice |url=https://web.stanford.edu/~johntayl/Onlinepaperscombinedbyyear/1993/Discretion_versus_Policy_Rules_in_Practice.pdf|journal=Carnegie-Rochester Conference Series on Public Policy |language=en |volume=39 |pages=195–214 |doi=10.1016/0167-2231(93)90009-L |issn=0167-2231}}</ref> 
* The formula incorporates unobservable parameters that can be easily misevaluated.<ref name="Boris Hofmann 2012" /> For example, the output gap cannot be precisely estimated.
* Forecasted variables such as the inflation and output gaps, are not accurate, depending on different scenarios of economic development.
* Difficult to assess the state of the economy early enough to adjust policy.
* The discretionary optimization that leads to stabilization bias and a lack of history dependence.<ref name="Lars E. O 2003" />{{Clarify|reason=gibberish|date=November 2022}}
* The rule does not consider financial parameters. 
* The rule does not consider other policy instruments such as reserve funds adjustment or balance sheet policies.<ref name="Boris Hofmann 2012" />
* The relationship between the interest rate and aggregate demand.<ref name="solvency" />

Taylor highlighted that the rule should not be followed blindly: "…There will be episodes where monetary policy will need to be adjusted to deal with special factors."<ref name="John B. Taylor 1993" />

==Criticisms==
[[Athanasios Orphanides]] (2003) claimed that the Taylor rule can mislead policymakers who face [[real-time data]]. He claimed that the Taylor rule matches the US funds rate less perfectly when accounting for informational limitations and that an activist policy following the Taylor rule would have resulted in inferior macroeconomic performance during the 1970s.<ref>{{cite journal |last=Orphanides |first=A. |year=2003 |title=The Quest for Prosperity without Inflation |journal=[[Journal of Monetary Economics]] |volume=50 |issue=3 |pages=633–663 |doi=10.1016/S0304-3932(03)00028-X |citeseerx=10.1.1.196.7048 |s2cid=14305730 }}</ref>

In 2015, "Bond King"{{clarify|date=February 2023}} [[Bill H. Gross|Bill Gross]] said the Taylor rule "must now be discarded into the trash bin of history", in light of tepid GDP growth in the years after 2009.<ref>{{cite web |url=https://www.cnbc.com/2015/07/30/gross-low-rates-are-the-problem-not-the-solution.html |title=Gross: Low rates are the problem, not the solution |work=CNBC |author=Bill Gross |date=July 30, 2015 |access-date=July 30, 2015|author-link=Bill H. Gross }}</ref> Gross believed that low interest rates were not the cure for decreased growth, but the source of the problem.

==See also==
*[[Monetary policy]]
*[[Monetary policy reaction function]]
*[[Fisher effect]]
*[[McCallum rule]]
*[[Friedman's k-percent rule]]
*[[Golden Rule (growth)]]
*[[Inflation targeting]]
*[[Inverted yield curve]]

==References==
{{Reflist|30em}}

==External links==
*[http://www.stanford.edu/~johntayl/PolRulLink.htm Resources from John Taylor's web site.]
*[http://www.federalreserve.gov/Pubs/FEDS/2007/200718/200718pap.pdf Federal Reserve paper on the Taylor Rule.]

{{Federal Reserve System}}
{{Central banks}}

{{DEFAULTSORT:Taylor Rule}}
[[Category:Federal Reserve System]]
[[Category:Monetary policy]]
[[Category:Monetary economics]]
[[Category:1992 introductions]]
[[Category:Eponymous laws of economics]]