How Useful Are Taylor Rules for Monetary Policy? By Sharon Kozicki ver the past several years, Taylor rules replaced by reasonable alternatives. For exam- have attracted increased attention of ple, rule recommendations would not be robust Oanalysts, policymakers, and the financial if different measures of price inflation yield a press. Taylor rules recommend a setting for the wide range of rule recommendations. If recom- level of the federal funds rate based on the state mendations differ considerably depending on of the economy. For instance, they may recom- whether price inflation is measured using the mend raising the federal funds rate when infla- core consumer price index or the chain price tion is above target or lowering the federal funds index for GDP, then the rule may not be very rate when a recession appears to be more of a useful. threat. Taylor rules have become more appealing recently with the apparent breakdown in the Rule recommendations should also be reliable. relationship between money growth and infla- A reliable rule might be expected to replicate tion (Blinder). But, while Taylor rules have federal funds rate settings over a period when attracted considerable interest, the usefulness of policymakers thought policy actions were suc- rule recommendations to policymakers has not cessful. If past policy decisions are regarded been well established. favorably, then policymakers may want to base current decisions on a similar strategy. To the To be useful to policymakers, rule recommen- extent rule recommendations replicate past favor- dations should be robust to minor variations in able policy settings, policymakers may regard the rule specification. While most analysts and the rule as reliable. But, even a rule that can policymakers agree on the fundamental features replicate favorable policy actions may not be of a monetary policy rule, consensus has not regarded as reliable if past policy decisions were been reached on the details of the specification. influenced by economic events beyond the scope The Taylor rule is a specific rule that incorpo- of the rule. rates several assumptions. Rule recommenda- tions should be robust if these assumptions are This article examines whether recommendations from Taylor rules are useful to policymakers as Sharon Kozicki is an assistant vice president and economist at the Federal Reserve Bank of Kansas City. Charmaine they decide how to adjust the federal funds rate. Buskas and Barak Hoffman, research associates at the The article suggests that the usefulness of Taylor bank, helped prepare the article. This article is on the rule recommendations to policymakers faced bank’s Website at www.kc.frb.org. with real-time policy decisions is limited. Rule 6 FEDERAL RESERVE BANK OF KANSAS CITY recommendations are not robust to reasonable inflation rate. The second factor is the equilib- minor variations in assumptions and their reli- rium real interest rate. When added together, ability is questionable.1 Taylor rules may be use- these two factors provide a benchmark recom- ful to policymakers in other ways. For example, mendation for the nominal federal funds rate. because they incorporate the overall characteris- The third factor is an inflation gap adjustment tics of sound monetary policy generally agreed on factor based on the gap between the inflation by analysts and policymakers, Taylor rules may rate and a given target for inflation.4 This factor provide a good starting point for discussions of recommends raising the federal funds rate above issues that concern policymakers. Monetary pol- the benchmark if inflation is above the target for icy rules also play an important role in most fore- inflation and lowering the federal funds rate casting models. below the benchmark if inflation is below the target. The fourth factor is an output gap adjust- The first section of the article describes the Tay- ment factor based on the gap between real GDP lor rule and discusses common generalizations of and potential real GDP. This factor recommends the Taylor rule. The second section examines the raising the federal funds rate above the bench- robustness of rule recommendations to small dif- mark if the gap is positive (real GDP is above ferences in rule specifications. The third section potential real GDP) and lowering the federal assesses the reliability of rule recommendations. funds rate below the benchmark if the gap is negative (real GDP is below potential real I. WHAT ARE TAYLOR-TYPE GDP). These factors summarize several impor- RULES? tant aspects of policy.5 This article focuses on a class of policy rules The sum of the first and second factors pro- that model the federal funds rate target as a func- vides a benchmark recommendation for the fed- tion of the deviation of inflation from a target rate eral funds rate that would keep inflation at its and the deviation of real GDP from potential real current rate, provided the economy is operating GDP (that is, its long-run sustainable trend).2 The at its potential. Because the benchmark recom- rules assume that policymakers seek to stabilize mendation rises one-for-one with the current output and prices about paths that are thought to rate of inflation, the higher current inflation is, be optimal and that by changing the federal funds the higher the rule recommendation will be, all rate target they can influence output and prices else equal. This relationship between current (Cecchetti). Such rules are often called Taylor inflation and the benchmark recommendation rules because they resemble a simple rule, known for the nominal federal funds rate keeps the as the Taylor rule, suggested by John Taylor in implied real interest rate constant. 1993. This section reviews the Taylor rule and discusses a class of similar rules that incorporate The use of the equilibrium real rate in the Taylor the same basic framework for policy. In the rule emphasizes that real rates play a central role remainder of the article, this class of similar rules in formulating monetary policy. Although the nom- will be referred to as Taylor-type rules to distin- inal federal funds rate is identified as the instru- guish them from the original Taylor rule. ment that policymakers adjust, the real interest rate is what affects real economic activity. In par- The Taylor rule ticular, the rules clarify that real interest rates will be increased above equilibrium when inflation is The Taylor rule recommends a target for the above target or output is above its potential. level of the nominal federal funds rate that depends on four factors.3 The first factor is the current The third and fourth factors in the Taylor rule ECONOMIC REVIEW l SECOND QUARTER 1999 7 summarize two objectives of monetary policy— target by one-half of the output gap, where the targeting a low and stable rate of inflation while output gap is defined as the percent deviation of promoting maximum sustainable growth. These the level of real GDP from the level of potential adjustment factors can also be seen as incorporat- real GDP.7 ing both long-run and short-run goals. The infla- tion gap adjustment factor incorporates the central Assumptions are embedded in all components bank’s long-run inflation goal. The output gap of the rule. Taylor-rule recommendations in a adjustment factor incorporates the view that in given quarter are based on the output gap in the the short-run policy should lean against cyclical same quarter and on inflation over the four quar- winds. Weights in the adjustment factors embody ters ending in the same quarter. In the Taylor a presumed attitude toward the short-run tradeoff rule, monetary policy targets GDP price infla- between inflation and output. tion measured as the rate of inflation in the GDP deflator over the previous four quarters. The The output gap adjustment factor may represent equilibrium real rate, represented by the second another aspect of policy. Some analysts have term on the right side of the expression, is assumed argued that the output gap adjustment factor to equal 2.0 percent. The inflation gap adjust- brings a forward-looking, or preemptive, motive ment incorporates a weight equal to one-half. to policy recommendations. According to this The policy target for inflation is assumed to view, a positive output gap signals likely future equal 2.0 percent. The output gap adjustment increases in inflation. Consequently, funds rate incorporates a weight equal to one-half. And, the recommendations that reflect an output gap output gap is constructed using a series for poten- adjustment may correspond to policy actions tial real GDP that grows 2.2 percent per year. designed to preempt an otherwise anticipated increase in inflation. Taylor-type rules Although the Taylor rule incorporates many Taylor presented his rule as a simple, representa- important aspects of policy, it also is based on tive specification that captured the general frame- several assumptions. Assumptions of some form work for policy discussed earlier. Because there are necessary to move from a framework for policy is a lack of consensus about the exact specification, to a rule that provides quantitative recommenda- evaluating alternative similar specifications is tions.6 The specific rule discussed by Taylor takes important when assessing the usefulness of rule the following form: recommendations. The details of the specifica- tions of the Taylor-type rules examined in this funds rate(t) = GDP price inflation(t) article differ somewhat from the Taylor rule, + 2.0 + 0.5 × (GDP price inflation(t) – 2.0) although they represent the same general frame- + 0.5 × (output gap(t)). (1) work for policy. The remainder of this section discusses specification details of the Taylor rule In this expression, the benchmark recommen- and alternative reasonable assumptions about tim- dation is the sum of GDP price inflation and the ing, weights, smoothing, and measurement that 2.0 percent equilibrium real rate.