The Taylor Rule in Plain Words

Central banks set a short-term policy interest rate to steer the economy, raising it to cool things down and lowering it to give things a boost. But how high or low should that rate be? In 1993, the economist John Taylor proposed a simple guideline that became known as the Taylor rule. It suggests a policy rate based on just two things: how far inflation is from the central bank’s goal, and how far the economy’s output is from its sustainable level. It is not a law any central bank must follow, but it has become one of the most widely used reference points for judging whether policy looks too tight or too loose.

The ingredients

The rule starts from a neutral interest rate - the rate that neither speeds up nor slows down the economy when inflation is at target and output is at its potential. It then makes two adjustments.

The first adjustment is for inflation. When inflation is above the central bank’s inflation target, the rule calls for a higher interest rate. Importantly, it says the rate should rise by more than inflation itself, so that the real interest rate - the rate after accounting for inflation - actually goes up and cools spending.

The second adjustment is for the output gap, which you met in the macroeconomics module. When the economy is producing above its potential, the rule calls for a higher rate. When the economy is producing below potential, as in a recession, it calls for a lower rate.

Taylor’s original version in words

In Taylor’s original example, the recommended policy rate equals current inflation, plus a neutral real rate that he assumed was 2 percent, plus half of the gap between inflation and a 2 percent target, plus half of the output gap. That sounds like a lot of pieces, but the logic is simple: start from a neutral level, then lean against inflation and lean against the output gap.

Why it is useful, and its limits

The Taylor rule offers a clear, consistent benchmark. Analysts compare a central bank’s actual rate with the rule’s suggestion to judge whether policy is unusually tight or loose. It also captures an important lesson from history: central banks that failed to raise rates strongly enough when inflation rose, as happened in many countries in the 1970s, tended to see inflation get worse.

But the rule has real limits. Both the neutral interest rate and the output gap cannot be observed directly and must be estimated, and different estimates can change the answer by a percentage point or more. The rule also ignores things central bankers care about, such as financial stability, exchange rates, and unusual shocks. And interest rates cannot easily go far below zero, so the rule’s suggestion in a deep recession may simply be impossible to follow.