The Taylor Rule is an interest rate forecasting model invented by famed economist John Taylor in 1992 and outlined in his 1993 study, "Discretion Versus Policy Rules in Practice." It suggests how central banks should change interest rates to account for inflation and other economic conditions.

The Taylor Rule suggests that the Federal Reserve should raise rates when inflation is above target or when gross domestic product (GDP) growth is too high and above potential. It also suggests that the Fed should lower rates when inflation is below the target level or when GDP growth is too slow and below potential.

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The Taylor Rule: Calculating Monetary Policy

The Taylor Rule Background

Taylor operated in the early 1990s with credible assumptions that the Federal Reserve determined future interest rates based on the rational expectations theory of macroeconomics. This is a backward-looking model that assumes if workers, consumers, and firms have positive expectations for the future of the economy, then interest rates don't need an adjustment.

Taylor noted that the problem with this model is not only that it is backward-looking, but it also doesn't take into account long-term economic prospects. This situation brought rise to the Taylor Rule.

Since its inception, the Taylor Rule has served not only as a gauge of interest rates, inflation, and output levels, but also as a guide to gauge proper levels of the money supply.

The Taylor Rule Formula

I=R*+PI+0.5 (IP-PI*)+0.5(Y-Y*)
The Taylor Rule Formula Example.  Investopedia

Where:

I = nominal fed funds rate
R* = real federal funds rate (usually 2%)
PI = rate of inflation
P* = target inflation rate
Y = logarithm of real output
Y* = logarithm of potential output

The product of the Taylor Rule is three numbers: an interest rate, an inflation rate and a GDP rate, all based on an equilibrium rate to gauge the proper balance for an interest rate forecast by monetary authorities.

This formula suggests that the difference between a nominal interest rate and a real interest rate is inflation. Real interest rates account for inflation while nominal rates do not. To compare rates of inflation, one must look at the factors that drive it.

Three Factors That Drive Inflation

Prices and inflation are driven by three factors: the consumer price index (CPI), producer prices, and the employment index. Most nations in the modern day look at the consumer price index as a whole rather than look at core CPI. This method allows an observer to look at the total picture of an economy in terms of prices and inflation since core CPI excludes food and energy prices.

Rising prices mean higher inflation, so Taylor recommends factoring the rate of inflation over one year (or four quarters) for a comprehensive picture.

He recommends the real interest rate should be 1.5 times the inflation rate. This is based on the assumption of an equilibrium rate that factors the real inflation rate against the expected inflation rate. Taylor calls this the equilibrium, a 2% steady state, equal to a rate of about 2%. But that's only part of the equation—output must be factored in as well.

To properly gauge inflation and price levels, apply a moving average of the various price levels to determine a trend and to smooth out fluctuations. Perform the same functions on a monthly interest rate chart. Follow the fed funds rate to determine trends.

Determining Total Economic Output

The total output of an economy can be determined by productivity, labor force participation, and changes in employment. For the Taylor Rule calculation, we look at real output against potential output.

The Taylor Rule looks at GDP in terms of real and nominal GDP, or what Taylor calls actual and trend GDP. It factors in the GDP deflater, which measures prices of all goods produced domestically. We do this by dividing nominal GDP by real GDP and multiplying this figure by 100.

The answer is the figure for real GDP. We are deflating nominal GDP into a true number to fully measure total output of an economy.

When inflation is on target and GDP is growing at its potential, rates are said to be neutral. This model aims to stabilize the economy in the short term and to stabilize inflation over the long term.

The Taylor Rule and Asset Bubbles

Some people thought the central bank was to blame—at least partly—for the housing crisis in 2007-2008. They assert that interest rates were kept too low in the years following the dot-com bubble and leading up to the housing market crash in 2008.

This is what causes asset bubbles, so interest rates must eventually be raised to balance inflation and output levels. A further problem of asset bubbles is money supply levels rise far higher than is needed to balance an economy suffering from inflation and output imbalances.

Had the central bank followed the Taylor rule during this time, which indicated the interest rate should be much higher, the bubble may have been smaller, as less people would have been incentivized to buy homes.