The Taylor Rule is an interest rate forecast model invented and perfected by famed Economist John Taylor in 1992 and outlined in his landmark 1993 study Discretion VS Policy Rules in Practice. Taylor operated in the early 1990’s with credible assumptions that the Federal Reserve determined future interest rates to be gauged based on the Rational Expectations Theory of Macroeconomics to name one major component.
This is a backward looking model that assumed if workers, consumers and firms believe future expectation of the economy is good, interest rates don’t need an adjustment. The model is not only backward looking but doesn’t take into account long term economic prospects.
The Phillips Curve was the last of discredited Rational Expectations Theory models that attempted to forecast the trade off between inflation and employment. The problem again was short term expectation may have been correct but what about long term assumptions based on these models and how can adjustments be made to an economy if the interest rate action taken was wrong.
Here monetary policy was based more on discretion than concrete rules. What we found was we can’t imply monetary expectations based on Rational Expectation Theories any longer particularly when an economy didn’t grow or stagflation was the result of recent interest rate change. So enter the Taylor Rule.
The formula looks like this. i= r* + pi + 0.5 (pi-pi*) + 0.5 ( y-y*). Here i= nominal fed funds rate, r*= the real federal funds rate (usually 2%), pi= rate of inflation, p* is the target inflation rate, y= logarithm of real output and y* = logarithm of potential output.
What this equation says is this. The difference between a nominal and real interest rate is inflation. Real interest rates are factored for inflation while nominal rates are not. Here we are looking at possible targets of interest rates. Yet that can’t be accomplished in isolation without looking at inflation.
To compare rates of inflation or non inflation, one must look at the total picture of an economy in terms of prices. Prices and inflation are driven by three factors, the Consumer Price Index, 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. Taylor recommends this method as core CPI excludes food and energy prices. This method allows an observer to look at the total picture of an economy in terms of prices and inflation.
Rising prices means higher inflation. So Taylor recommends factoring the rate of inflation over one year or four quarters for a comprehensive picture.Taylor recommends the real interest rate should be 1 1/2 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 equalled to a rate of about 2 %. Another way to look at this is the coefficients on the deviation of real GDP from trend GDP and the inflation rate. Both methods are about the same for forecasting purposes. But that’s only half of the equation. Output must be factored.
The total output picture of an economy is determined by productivity, labor force participation and changes in employment.
For the equation we look at real output against potential output. Logarithms is the term used. What is logarithms?
Exponents. Logarithms is one means to factor this aspect of the equation. We must look at GDP in terms of real and nominal GDP or to use the words of John Taylor, actual vs trend GDP. To do this, we must factor the GDP Deflator that measures prices of all goods produced domestically.
Factor nominal GDP divided by real GDP times 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.
The product of the Taylor Rule is three numbers, an interest rate, an inflation rate, a GDP rate with all based on an equilibrium rate to gauge exactly the proper balance for an interest rate forecast by monetary authorities.
The rule for policymakers is this. The Federal Reserve should raise rates when inflation is above target or when GDP growth is too high and above potential. The Fed should lower rates when inflation is below the target level or when GDP growth is to slow and below potential.
When inflation is on target and GDP is growing at potential, rates are said to be neutral. This model has as its short term goal to stabilize the economy and a long term goal to stabilize inflation.
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.
The Taylor Rule has held many central banks around the world in good stead since its inception in 1993. It has served not only as a gauge of interest rates, inflation and output levels but it can equally serve as a guide to gauge proper levels of the money supply since money supply levels and inflation meld together to form a perfect economy. It allows us to understand money vs prices to gauge a proper balance because inflation can erode the purchasing power of the dollar if its not leveled properly.
While the Taylor Rule has served economies in good economic times, it can also serve as a gauge for bad economic times.
Suppose a central bank held interest rates to low for to long. This prescription 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. Since 1993, the Taylor Rule has been the order of the day that has not only lived up to expectations but any criticisms have been muted responses without real bases of arguments.
January 2010 Brian Twomey
Brian Twomey is a currency trader and adjunct professor of Political Science at Gardner-Webb University