Taylor’s Rule

Taylor’s rule is a tool used by central banks to estimate the target short-term interest rate when expected inflation rate differs from target inflation rate and expected growth rate of GDP differs from long-term growth rate of GDP. The central banks attempt to achieve the new target rate by using the tools of monetary policy, mainly the open market operations.

Taylor’s rule was developed by economist John Taylor. Studies have shown that actions of the Federal Reserve and other central banks in developed countries can be predicted by the rule.

In accordance with the rule, the central banks are expected to increase short-term interest rates when expected inflation rate is higher than target inflation rate, expected GDP growth rate is higher than long-term GDP growth rate or both. Similarly, short-term interest rates are decreased when expected inflation rate is below target, expected GDP growth rate is below long-term trend or both.

Formula

Where,
Target rate is the short-term interest rate which the central bank should target;
Neutral rate is the short-term interest rate that prevails when the difference between the actual rate of inflation and target rate of inflation and difference between expected GDP growth rate and long-term growth rate in GDP are both zero;
GDP_e is expected GDP growth rate;
GDP_t is long-term GDP growth rate;
I_e is expected inflation rate; and
I_t is target inflation rate

Example

Eric Goodman and you are working as financial analysts specializing in debt securities research at a boutique investment management firm. In January 20X5 when the economy was growing at its long-term growth rate and inflation was at its target rate of 2%, the Federal Reserve had a target short-term interest rate of 4%. It is 24 February 20X5 and the Federal Open Market Committee (FOMC) is due to meet in couple days to decide whether to change the short-term interest rate or not. Eric is looking for clues to help him predict the most likely decision of the FOMC. He approached you with some data as shown below:

Help Eric predict the outcome of the FOMC meeting.

Taylor’s rule is a good tool to predict the FOMC decisions related to short-term interest rate.

Target short term rate = 4% + 0.5 × (3% − 2.5%) + 0.5 × (4% − 2%) = 5.25%

Based on the new data the FOMC is most likely going to revise the short-term interest rate upwards by 1.25% to the new target of 5.25%. The increased expected inflation rate and expected GDP growth relative to their respective targets has necessitated increase in interest rates in order to cool the economy down.

by Obaidullah Jan, ACA, CFA and last modified on Feb 17, 2018