What is the “Taylor Rule”? How does it relate to the Federal Reserve's interest rate decisions?

Okay, no problem. Below, I'll explain the 'Taylor Rule,' a concept that might sound a bit complex, in a way an average person can understand.

What is the 'Taylor Rule'? How Does It Influence the Fed's Interest Rate Decisions?

Hello! Seeing this question, I bet you're interested in the Fed's rate hikes and cuts, which are often mentioned in financial news. Well, the 'Taylor Rule' is a great tool for understanding the logic behind these decisions.

You can think of it as an 'interest rate adjustment recipe' prepared for the Fed.

This recipe was proposed in 1993 by Stanford economist John Taylor. Its purpose is to provide central banks (like the Fed) with a simple, clear formula that tells them what interest rate level is appropriate under different economic conditions.

What are the 'Ingredients' in the Taylor Rule's Recipe?

The core idea of this recipe is simple: it primarily focuses on two major concerns for the Fed: inflation and economic growth.

Specifically, it considers the following key 'ingredients':

Current Inflation Rate vs. Target Inflation Rate
- The Fed has an ideal inflation target in mind, usually 2%.
- The first step in the recipe is to see: Is the current inflation rate higher or lower than 2%?
- If inflation is too high (e.g., 5%), it's like a dish being too salty and needing water. The rule would suggest raising interest rates to cool down the economy and curb prices.
- Conversely, if inflation is too low, it suggests lowering interest rates.
The Economy's 'Heat' vs. 'Cold'
- This refers to the gap between the economy's actual output and its 'potential.' For us average people, this can be understood as whether economic growth is too fast or too slow.
- If the economy is 'overheating' (e.g., extremely low unemployment, rampant investment and consumption), it means growth is exceeding its sustainable level, potentially leading to severe inflation in the future. In this situation, the rule would suggest raising interest rates to encourage a slowdown.
- If the economy is 'too cold' (e.g., high unemployment, underutilized factories), risking a recession, the rule would suggest lowering interest rates to stimulate investment and consumption.
A 'Neutral' Baseline Interest Rate
- This can be understood as a comfortable interest rate level when the economy is neither too hot nor too cold, and inflation is right on target.

Simply put, the Taylor Rule's formula is:

Suggested Interest Rate = Neutral Rate + (Adjustment for Inflation Deviation) + (Adjustment for Economic Output Gap)

By mixing these 'ingredients' in certain proportions, the Taylor Rule calculates a suggested federal funds rate.

So, Does the Fed Strictly Follow This 'Recipe'?

The answer is: No, it does not.

This is a very crucial point. The Taylor Rule is more like a GPS navigator than a law that must be strictly followed.

A GPS suggests an optimal route, but the driver (the Fed) makes decisions based on actual road conditions. For example, if the navigation says to go straight, but the driver sees a car accident ahead (like a sudden financial crisis or a global pandemic), they will certainly choose a detour.
The world is far more complex than a formula. The Taylor Rule doesn't include all variables, such as financial market stability, international geopolitical risks, or technological changes. These are all factors that the Fed Chair and committee members must carefully consider and deliberate during their meetings.
The 'ingredients' themselves are hard to measure precisely. For instance, economists constantly debate what the 'neutral interest rate' and 'economic potential' (mentioned earlier) actually are. Using estimated data for calculations means the result is naturally only a reference.

If It's Not Followed Strictly, What's Its Use?

While the Fed doesn't blindly follow the Taylor Rule, it remains very important, primarily in three aspects:

An Important 'Anchor' or Reference Point
- It provides markets and the public with a benchmark for gauging whether the Fed's policy is 'loose' or 'tight.' When the Fed's actual interest rate is significantly below the Taylor Rule's suggestion, people know that current policy is very accommodative (i.e., 'pumping money into the economy'); conversely, it means they are 'withdrawing money from the economy.'
A Systematic Thinking Framework
- It helps Fed policymakers systematically consider the two core objectives of inflation and employment, preventing arbitrary decisions.
Increases Policy Transparency
- During congressional hearings, members often ask the Fed Chair: 'According to the Taylor Rule, the interest rate should be X%, so why have you set it at Y%?' This forces the Fed to clearly explain the logic and considerations behind their decisions to the public.

In Summary

The Taylor Rule is a simple formula, like a 'recipe' or 'navigator,' that tells the Fed what a 'reasonable' interest rate level should be given current inflation and economic growth.
It primarily considers inflation and the economy's 'heat' and 'cold'. If inflation is too high or the economy is overheating, it suggests raising rates; conversely, it suggests lowering rates.
The Fed does not blindly follow it, as the real world is far more complex. It serves only as an important reference tool.
Its existence provides a reference benchmark for the Fed's decisions and allows outsiders to better understand and oversee its monetary policy.

Hope this explanation helps you!