Taylor Rule
The Taylor Rule is a monetary policy guideline prescribing how a central bank should set its short-term interest rate based on deviations of inflation from its target and of real GDP from its potential, providing a systematic framework for evaluating whether policy is tight or accommodative.
Economist John Taylor introduced the Taylor Rule in a 1993 paper as an ex-post description of how the Federal Reserve had actually set the federal funds rate during the 1987-1992 period — and as a normative prescription for how it should do so going forward. The formula is deceptively simple: start with the neutral real interest rate, add the central bank's inflation target, then add half of the inflation gap (actual inflation minus target) and half of the output gap (actual GDP minus potential GDP, expressed as a percentage).
The original Taylor Rule used a neutral real rate of 2%, an inflation target of 2%, and equal weights of 0.5 on both the inflation gap and the output gap. Under this specification, if inflation runs 1 percentage point above target while output is exactly at potential, the prescribed federal funds rate rises by 0.5 percentage points above the neutral level. If the economy is running 2 percentage points below potential with inflation on target, the rule prescribes a rate 1 percentage point below neutral.
The elegance of the Taylor Rule is that it encodes both sides of the Fed's dual mandate in a single formula. When inflation is elevated, the rule calls for rate hikes; when the economy is weak, it calls for rate cuts. The rule also implies a systematic, rule-based approach that reduces discretionary policy surprises, which in theory anchors inflation expectations more effectively.
In practice, the Fed does not mechanically follow any single rule, and the Taylor Rule is best understood as one input among many in a complex deliberative process. Several variants exist — most notably the 'balanced approach' rule adopted during and after the Great Financial Crisis, which places greater weight on the employment gap. The choice of the neutral real rate is particularly contested: in the 2010s, many economists argued the neutral rate had fallen well below 2%, implying the Taylor Rule would prescribe negative nominal rates.
Financial markets watch Taylor Rule calculations closely because they provide a framework for evaluating whether Fed policy is accommodative or restrictive relative to economic conditions. When the actual federal funds rate sits well below the Taylor Rule prescription, it signals an accommodative stance that tends to support risk assets. When the actual rate exceeds the rule prescription, tighter financial conditions may weigh on equities and credit spreads.