Taylor rule
The rule was proposed in 1992 by American economist John B. Taylor[1] for central banks to use to stabilize economic activity by appropriately setting short-term interest rates.
[2] The rule considers the federal funds rate, the price level and changes in real income.
In the United States, the Federal Open Market Committee controls monetary policy.
While the rule provides a systematic framework that can enhance policy predictability and transparency, critics argue that its simplified formula—focusing primarily on inflation and output—may not adequately capture important factors such as financial stability, exchange rates, or structural changes in the economy.
[10] That is, the rule produces a relatively high real interest rate (a "tight" monetary policy) when inflation is above its target or when output is above its full-employment level, in order to reduce inflationary pressure.
It recommends a relatively low real interest rate ("easy" monetary policy) in the opposite situation, to stimulate output.
Sometimes monetary policy goals may conflict, as in the case of stagflation, when inflation is above its target with a substantial output gap.
In such a situation, a Taylor rule specifies the relative weights given to reducing inflation versus increasing output.
In his opinion, Federal Reserve policy regarding the price level could not guarantee long-term stability.
After the death of Governor Strong in 1928, political debate on changing the Fed's policy was suspended.
[12] Later on, monetarists such as Milton Friedman and Anna Schwartz agreed that high inflation could be avoided if the Fed managed the quantity of money more consistently.
[4] The economic downturn of the early 1960s in the United States occurred despite the Federal Reserve maintaining relatively high interest rates to defend the dollar under the Bretton Woods system.
After the collapse of Bretton Woods in 1971, the Federal Reserve shifted its focus toward stimulating economic growth through expansionary monetary policy and lower interest rates.
Beginning in the mid-1970s, central banks increasingly adopted monetary targeting frameworks to combat inflation.
During the Great Moderation from the mid-1980s through the early 2000s, major central banks including the Federal Reserve and the Bank of England generally followed policy approaches aligned with the Taylor rule, which provided a systematic framework for setting interest rates.
A significant shift in monetary policy frameworks began in 1990 when New Zealand pioneered explicit inflation targeting.
The Reserve Bank of New Zealand underwent reforms that enhanced its independence and established price stability as its primary mandate.
[7] From the early 2000s onward, major central banks in advanced economies, particularly the Federal Reserve, maintained policy rates consistently below levels prescribed by the Taylor rule.
This deviation reflected a new policy framework where central banks increasingly focused on financial stability while still operating under inflation-targeting mandates.
This pattern became especially pronounced following shocks like the dot-com bubble burst, the 2008 financial crisis, and subsequent economic disruptions, leading to extended periods of accommodative monetary policy.
According to some New Keynesian macroeconomic models, insofar as the central bank keeps inflation stable, the degree of fluctuation in output will be optimized (economists Olivier Blanchard and Jordi Gali call this property the 'divine coincidence').
[13] The inflation target and output gap are neglected, while the interest rate is conditional upon the solvency of workers and firms.
It also introduced the concept of targeting the forecast, such that policy is set to achieve the goal rather than merely to lean in one direction or the other.
Although the Federal Reserve does not follow the Taylor rule,[17] many analysts have argued that it provides a fairly accurate explanation of US monetary policy under Paul Volcker and Alan Greenspan[18][19] and other developed economies.
[20][21] This observation has been cited by Clarida, Galí, and Gertler as a reason why inflation had remained under control and the economy had been relatively stable in most developed countries from the 1980s through the 2000s.
[22][23] Some research has reported that households form expectations about the future path of interest rates, inflation, and unemployment in a way that is consistent with Taylor-type rules.
Taylor highlighted that the rule should not be followed blindly: "…There will be episodes where monetary policy will need to be adjusted to deal with special factors.
"[3] Athanasios Orphanides (2003) claimed that the Taylor rule can mislead policymakers who face real-time data.
[27] In 2015, "Bond King"[clarification needed] Bill Gross said the Taylor rule "must now be discarded into the trash bin of history", in light of tepid GDP growth in the years after 2009.
[28] Gross believed that low interest rates were not the cure for decreased growth, but the source of the problem.
