What is Taylor's rule and what does it say about Federal Reserve monetary
Taylor's rule is a formula developed by Stanford economist John Taylor.
It was designed to provide "recommendations" for how a central bank like
the Federal Reserve should set short-term interest rates as economic conditions
change to achieve both its short-run goal for stabilizing the economy
and its long-run goal for inflation.
Specifically, the rule states that the "real" short-term interest rate
(that is, the interest rate adjusted for inflation) should be determined
according to three factors: (1) where actual inflation is relative to
the targeted level that the Fed wishes to achieve, (2) how far economic
activity is above or below its "full employment" level, and (3) what the
level of the short-term interest rate is that would be consistent with
full employment. The rule "recommends" a relatively high interest rate
(that is, a "tight" monetary policy) when inflation is above its target
or when the economy is above its full employment level, and a relatively
low interest rate ("easy" monetary policy) in the opposite situations.
Sometimes these goals are in conflict: for example, inflation may be above
its target when the economy is below full employment. In such situations,
the rule provides guidance to policy makers on how to balance these competing
considerations in setting an appropriate level for the interest rate.
Although the Fed does not explicitly follow the rule, analyses show
that the rule does a fairly accurate job of describing how monetary
policy actually has been conducted during the past decade under Chairman
Greenspan. This fact has been cited by many economists inside and outside
of the Fed as a reason that inflation has remained under control and that
the economy has been relatively stable in the US over the past ten years.
Judd, John P. and Bharat Trehan. 1995. "Has the Fed Gotten Tougher on
Inflation?" FRBSF Weekly Letter, Number 95-13, March 31.
Taylor, John B. 1993. "Discretion Versus Policy Rules in Practice,"
Carnegie-Rochester Conference Series on Public Policy, 39, pp.