Many observers suspect that the Fed
under Greenspan and Bernanke has followed the so-called Taylor
Rule, named after the Stanford University economist, John Taylor,
who developed it. The rulestates that
fft = π + ff*r + ½(π gap) + ½(Y gap)
where
fft = federal funds
target
π = inflation
ff*r = the real equilibrium
fed funds rate
π gap = inflation gap (π – π
target)
Y gap = output gap (actual output [e.g.
GDP] − output potential)
So if the inflation target was 2
percent, actual inflation was 3 percent, output was at its
potential, and the real federal funds rate was 2 percent, the
Taylor Rule suggests that the fed funds target should be
fft = π + ff*r + ½(π gap) + ½(Y gap)
fft = 3 + 2 + ½(1) + ½(0)
fft = 5.5
If the economy began running a
percentage point below its potential, the Taylor Rule would suggest
easing monetary policy by lowering the fed funds target to 5
percent:
fft = 3 + 2 + ½(1) + ½(−1)
fft = 3 + 2 + .5 + −.5 = 5
If inflation started to heat up to 4
percent, the Fed should respond by raising the fed funds target to
6.5:
fft = 4 + 2 + ½(2) + ½(−1) = 6.5
Practice calculating the fed funds
target on your own in Exercise 1.
exercise
1. Use the Taylor Rule—fft = π + ff*r +
½(π gap) + ½(Y gap)—to determine what the federal funds target
should be if:
Inflation
Equilibrium Real Fed Funds Rate
Inflation Target
Output
Output Potential
Answer: Fed Funds Target
0
2
1
3
3
1.5
1
2
1
3
3
3
2
2
1
3
3
4.5
3
2
1
3
3
6
1
2
1
2
3
2.5
1
2
1
1
3
2
1
2
1
4
3
3.5
1
2
1
5
3
4
1
2
1
6
3
4.5
7
2
1
7
3
14
Notice that as actual inflation exceeds the target, the Taylor
Rule suggests raising the fed funds rate (tightening monetary
policy). Notice too that as output falls relative to its potential,
the rule suggests decreasing the fed funds rate (easier monetary
policy). As output exceeds its potential, however, the rule
suggests putting on the brakes by raising rates. Finally, if
inflation and output are both screaming, the rule requires that the
fed funds target soar quite high indeed, as it did in the early
1980s. In short, the Taylor Rule is countercyclical and
accounts for two important Federal Reserve goals: price stability
and employment/output.
The Taylor Rule nicely explains U.S. macroeconomic history
since 1960. In the early 1960s, the two were matched:
inflation was low, and growth was strong. In the latter part of the
1960s, the 1970s, and the early 1980s, actual ff* was generally
well below what the Taylor Rule said it should be. In that period,
inflation was so high we refer to the period as the Great
Inflation. In the latter part of the 1980s, ff* was higher than
what the Taylor Rule suggested. That was a period of weak growth
but decreasing inflation. From 1990 or so until the early 2000s, a
period of low inflation and high growth, the Taylor Rule and ff*
were very closely matched. In the middle years of the first decade
of the new millennium, however, the Fed kept ff* well below the
Rule and thereby fueled the housing bubble that led to the 2007–8
crisis. Since then, the economy has been weak and little wonder:
the Fed lowered rates to zero, but that was still well above the
negative 7 percent or so called for by the rule. Figure 17.2 graphs
the latter portion of the story.
Examine Figure 17.3 carefully. Assuming
the Fed uses the Taylor Rule, what happened to inflation and output
from mid-2003 until mid-2006. Then what happened?
Assuming that the Fed’s inflation
target, the real equilibrium federal funds rate, and the economy’s
output potential were unchanged in this period (not bad
assumptions), increases in actual inflation and increases in actual
output would induce the Fed, via the Taylor Rule, to increase its
feds fund target. Both were at play but were moderating by the end
of 2006, freezing the funds target at 5.25 percent, as shown in
Figure 17.4 . Then the subprime mortgage crisis, recession, and
Panic of 2008 struck, inducing the Fed quickly to lower its target
to 3, then 2, then 1, then almost to zero.
None of this means, however, that the Fed will continue to use
the Taylor Rule, if indeed it does so.www.frbsf.org/education/activities/drecon/9803.html
Nor does it mean that the Taylor Rule will provide the right policy
prescriptions in the future. Richard Fisher and W. Michael Cox, the
president and chief economist of the Dallas Fed, respectively,
believe that globalization makes it increasingly important for the
Fed and other central banks to look at world inflation and output
levels in order to get domestic monetary policy right.See Richard
W. Fisher and W. Michael Cox, “The New Inflation Equation,”
Wall Street Journal, April 6, 2007, A11.
Stop and Think Box
Foreign exchange rates can also flummox
central bankers and their policies. Specifically, increasing
(decreasing) interest rates will, ceteris paribus, cause a currency
to appreciate (depreciate) in world currency markets. Why is that
important?
The value of a currency directly
affects foreign trade. When a currency is strong relative to other
currencies (when each unit of it can purchase many units of foreign
currencies), imports will be stimulated because foreign goods will
be cheap. Exports will be hurt, however, because domestic goods
will look expensive to foreigners, who will have to give up many
units of their local currency. Countries with economies heavily
dependent on foreign trade must be extremely careful about the
value of their currencies; almost every country is becoming more
dependent on foreign trade, making exchange rate policy an
increasingly important one for central banks worldwide to
consider.
key takeaways
The Taylor Rule is a simple equation—fft = π +
ff*r + ½( π gap) + ½(Y gap)—that allows central bankers
to determine what their overnight interbank lending rate target
ought to be given actual inflation, an inflation target, actual
output, the economy’s potential output, and an estimate of the
equilibrium real fed funds rate.
When the Fed has maintained the fed funds rate near that
prescribed by the Taylor Rule, the economy has thrived; when it has
not, the economy has been plagued by inflation (when the fed funds
rate was set below the Taylor rate) or low output (when the fed
funds rate was set above the Taylor rate).