What is the Taylor rule?

The Taylor rule, proposed by Stanford economist John Taylor in 1993, is a formula for calculating the appropriate federal funds rate based on two variables: the gap between actual and target inflation, and the gap between actual and potential economic output. The original specification sets the funds rate equal to the inflation rate plus 0.5 times the inflation gap (actual minus target) plus 0.5 times the output gap (actual minus potential GDP), plus a constant for the equilibrium real rate.

In its simplest form: Rate = r* + inflation + 0.5 x (inflation - 2%) + 0.5 x (output gap). If the equilibrium real rate (r*) is 2%, actual inflation is 3%, and the output gap is 1%, the Taylor rule prescribes a funds rate of 2% + 3% + 0.5% + 0.5% = 6%. This mechanical calculation provides a benchmark that analysts can compare against the actual federal funds rate to assess whether the Fed is leaning hawkish or dovish relative to its mandate.

The rule has been modified extensively since 1993. The "balanced approach" version, which the Fed has cited, places a weight of 1.0 rather than 0.5 on the output gap, making the rule more responsive to unemployment. The "inertia" version adds a smoothing parameter, recognizing that the Fed adjusts rates gradually rather than jumping to the prescribed level. Different assumptions about r*, the inflation measure (headline vs core, CPI vs PCE), and the output gap estimate produce significantly different rate prescriptions.

The Taylor rule is not a policy tool the Fed follows mechanically; rather, it serves as a reference point in policy discussions. When the actual funds rate sits well below the Taylor rule prescription, it suggests the Fed is running accommodative policy, as was the case during most of 2021-2022 before the aggressive hiking cycle began. When the actual rate exceeds the Taylor rule, it suggests the Fed may be overly restrictive. The rule's main value lies in disciplining the policy debate and providing a transparent framework for evaluating whether rates are approximately right given current economic conditions.