Taylor’s Rule

Key takeaways

• Taylor’s Rule is a simple guideline for setting a short-term nominal interest rate based on inflation and the output gap.
• It links the policy rate to current inflation and the deviation of real GDP from its long-run trend (the output gap), placing substantial weight on inflation.
• The rule works well as a benchmark in stable conditions but can prescribe infeasible or inappropriate policy during crises (e.g., when the effective lower bound binds).
• Central banks and researchers use modified versions that change weightings, replace the output gap with an unemployment gap, or account for constraints such as the zero lower bound.

What the Taylor Rule is

The Taylor Rule, proposed by John B. Taylor in 1993, is an empirical policy rule that relates a central bank’s target short-term nominal interest rate to two factors:
* The inflation rate (relative to an inflation target), and
* The output gap (the percentage difference between actual real GDP and potential GDP).

It produces a recommended policy rate that rises when inflation or output exceed their targets and falls when they are below target.

The equation (standard form)

A commonly cited form of the rule is:

r = p + 0.5y + 0.5(p − 2) + 2

Where:
* r = recommended nominal federal funds rate (percent)
p = current inflation rate (percent)
y = percent deviation of real GDP from its long-term trend (output gap)

Interpretation:
* The rule assumes a neutral real interest rate of about 2% (the “+2” term).
It raises the nominal rate by 0.5 percentage points for every 1 percentage point the inflation rate exceeds the 2% target, and by 0.5 points for every 1 percentage point the output gap is positive.
If inflation and output are on target, the rule implies a nominal rate roughly equal to inflation plus the neutral real rate.

(Algebraically the expression can be rearranged; the form above reflects Taylor’s original presentation.)

How policymakers use it

• Benchmark: Central banks treat the rule as a benchmark—one useful input among many—rather than a mechanical prescription.
• Communication: It provides a transparent, rule-based way to communicate the logic of policy decisions.
• Comparison: Economists use it to evaluate whether historical policy was “tight” or “loose” relative to a simple rule.

Limitations and critiques

• Zero (or effective) lower bound: During deep recessions, the rule can prescribe negative nominal rates; in practice, the policy rate is constrained near zero, forcing use of other tools (e.g., quantitative easing).
• Single-instrument focus: The basic rule only adjusts the short-term rate and does not account for alternative tools (asset purchases, forward guidance, balance-sheet measures).
• Symmetric weighting and predictability assumptions: The rule treats deviations in inflation and output symmetrically and assumes these variables are reasonably predictable—assumptions that can break down in crises.
• Oversimplification: Real-world policy must weigh financial stability, employment, and uncertainty; the Taylor Rule omits many practical considerations central banks face.
• Model and data sensitivity: Different measures of inflation (CPI vs. PCE), different estimates of potential GDP, and alternative weightings produce different prescriptions.

Common variations and adaptations

• Different weightings: Some versions give more weight to the output gap to reflect an employment objective; others emphasize inflation.
• Alternative gaps: The output gap is sometimes replaced with the unemployment gap (difference between current unemployment and its long-run rate) to align with employment mandates.
• Balanced or delayed-adjustment rules: Modifications can delay rate moves or adjust the response when the policy rate is near its effective lower bound.
• Use in policy evaluation: Central banks often report several rule-based benchmarks (including variants of the Taylor Rule) in their policy reports to illustrate options under different assumptions.

Practical perspective

Taylor himself and many central bankers view the rule as a useful organizing framework rather than a rigid command. It clarifies the trade-offs between inflation control and economic slack, but policymakers supplement it with judgment, other models, and non-rate tools—especially during financial stress or when the policy rate cannot move freely.

Further reading

• Taylor, John B., “Discretion Versus Policy Rules in Practice,” Carnegie-Rochester Conference Series on Public Policy, 1993.
• Board of Governors of the Federal Reserve System, Monetary Policy Reports and related discussions of rule-based approaches.