Monetary Policy Rules, Interest Rates, and Taylor's Rule

Monetary policy is the guide that central banks use to manage money, credit, and interest rates in the economy to achieve its economic goals. A primary purpose of a central bank is to promote growth and restrict inflation. The monetary tools used to achieve these objectives involve changing the size of the monetary base or changing the interest rate. However, the link between the monetary base, which is the amount of currency held by the public + banking reserves, and the economy is weak, because the effect of the quantity of money on the economy depends not only on the size of the monetary base but also on the velocity of money — how quickly either banks lend out the money or people spend it.

Interest rates have a more direct link to the economy, so central banks target interest rates to regulate the economy. Because central banks regulate the banks within their country and because the interbank lending rate, which is the interest rate that banks charge each other for overnight loans, affects almost every other interest rate, central banks usually target the interbank lending rate. In the United States, the interbank lending rate is the federal funds rate. Lowering interest rates stimulates the economy by providing cheaper credit, while higher interest rates slows the economy by making credit more expensive.

However, the relationship between interest rates and the economy is not a simple one. Furthermore, there is generally a long lag between changes in the interest rate and the consequential changes in the economy. Therefore, most central banks have changed the interest rate slowly, then waited to see what effect it would have. Because of this feedback lag, many economists sought a rule that would allow central bankers to choose an interest rate that would more closely achieve their economic objectives than would be possible with just discretion. Naturally, this rule would relate the interest rate to targeted economic objectives that respond to changes in the interest rate, since a rule based on prices and real output is better than one based on the quantity of money or the foreign exchange rate because price levels and real output are the general economic objectives of most central banks.

One such rule has been developed by John B. Taylor, an economist at Stanford University, which, unsurprisingly, has come to be known as Taylor's Rule.

Taylor's Rule

Although central banks of other countries, such as Columbia, are using Taylor's Rule, the rule was developed from information provided by the Federal Reserve and its accuracy was compared with the actual target federal funds rate chosen by the Federal Reserve during the decade before the rule was published.

Taylor, in part, developed his rule by simulating economic performance of the G-7 countries under different monetary policy rules, then ranked their performance in their success of achieving price and output stability.

Taylor's Rule, published in 1992, is not intended to be followed mechanically nor is it intended to be used when quick action is required, such as after the stock market crash in October 19, 1987. Taylor said that a policy formula could be used in 2 ways: as one input to consider when formulating policy and as a means of characterizing the important properties that relate inflation to employment, price levels, and actual output.

Although the actual equation used to determine Taylor's Rule varies, depending on what central bankers consider more important and on the constant used for the long-term real interest rate, the equation has the following general format:

Target Interest Rate = Long-Term Real Interest Rate + Current Inflation + ½ Inflation Gap + ½ Output Gap

To measure inflation, the Fed uses the price index for Personal Consumption Expenditures, which is considered more accurate than the Labor Department's Consumer Price Index, since many economists believe that the Consumer Price Index overestimates inflation.

Note that when the actual inflation rate is higher than the target rate, then the inflation gap is positive; likewise when the output gap exceeds the natural output rate. When the output gap exceeds natural rate, then the economy tends to overheat, leading to increased inflation.

Note that when the inflation rate is above the target rate, then Taylor's Rule calls for an increase in the target interest rate of 1.5% for each percentage increase in the inflation rate, assuming that there is no output gap.

Taylor's Rule is often modified to include currency fluctuations or capital controls, especially for smaller economies, and many central bankers also change the coefficients for the inflation gap and the output gap, depending on what central bankers considered more important or that is more in line with their objectives.

Taylor's Rule has several drawbacks. Since the rule is based on the inflation rate and the output gap measured over a duration, it cannot correct sudden jolts to the economy, such as a terrorist attack, nor can it accurately correct for changes in the economy due to other factors, such as the irresponsible extension of credit to subprime borrowers before the 2007 Great Recession.

Since an equation can be no more accurate than its input parameters and economic data is revised many times after the first release, the lack of real-time information about the economy makes any monetary policy rule less useful. Central bankers get their information about the economy from their large staff who gather the information and analyze it. However, the economic data usually becomes more accurate as more information is gathered later. GDP growth, for instance, is often revised repeatedly, sometimes over 5 years or more.