Taylor Rule

The Taylor rule is a formula introduced by economist John Taylor in 1993 that guides Federal Reserve interest rate policy based on economic data. It recommends ==raising the federal funds rate when inflation exceeds the target (2%) or GDP exceeds potential (high output), and lowering it otherwise, aiming for economic stability==. 

Key Components of the Taylor Rule 

• Targeted Rate Formula: The nominal federal funds rate is calculated as: $FFR_{}t=r_{t}^{LR}+ \pi_{t} + 0.5(\pi_{t}−\pi^{*})+0.5(y_{t}−y_{t}^{P}),$ where $r^{LR}$ is the long-run neutral interest rate, $\pi$ is current inflation, $\pi^{*}$ is the 2% inflation target, and $y_{t} - y_{t}^{P}$ is the output gap.
• The Taylor Principle: To maintain stability, the Fed should raise nominal interest rates by more than the increase in inflation (i.e., by more than 1-for-1). This ensures the real interest rate rises, cooling the economy.
• Economic Drivers: The rule advises adjusting rates based on two primary factors:
  1. Inflation Gap: How far current inflation deviates from the target (typically 2%).
  2. Output Gap (or Unemployment): The difference between actual GDP and potential GDP (or, in some versions, unemployment relative to full employment). 

Application and Limitations 

• Not a Strict Rule: The Fed uses this rule as a benchmark or guideline rather than a mandatory formula, as it does not capture all complexities of economic policy.
• Policy Evaluation: The rule is frequently used to analyze whether past Fed actions were appropriate, such as during the 1970s (too low) or 1980s (too high), as noted by the Federal Reserve Bank of Richmond.
• Alternative Versions: While the original formula used a 0.5 coefficient for both inflation and output gaps, alternative versions (often termed “simple rules”) are used to evaluate policy under different assumptions. 

The principle fundamentally argues that proactive, systematic adjustments to interest rates in response to inflation and economic output are crucial for maintaining economic stability.