What John Taylor’s Rule Could Mean for the Fed

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How Markets Would React to a Powell, Taylor Fed

With Stanford University economist John Taylor under consideration by U.S. President Donald Trump to run the Federal Reserve, investors are zeroing in on a mathematical equation Taylor designed in the early 1990s to guide the setting of interest rates. Judging from movements in financial markets, many investors have concluded that Taylor’s rule, if implemented as policy, would cause the central bank to raise rates at a faster pace. But that may not be the right conclusion.

John Taylor

Photographer: Andrew Harrer/Bloomberg

1. What is the Taylor rule?

At Carnegie Mellon University in Pittsburgh in 1992, Taylor first outlined his ideas for how inflation and growth figures can be used to set interest rates. He elaborated in a 1993 paper on how a central bank’s benchmark interest rate should be adjusted based on inflation and economic growth. (Unemployment is now often used as a substitute for growth.) So simple is the formula that Taylor once inscribed it on his business cards, and central banks around the world use it informally to guide policy. Taylor is often mentioned as a possible future winner of the Nobel Prize for economics.

2. What impact would the rule have today?

Generally speaking, interest rates would be higher at the moment if the Taylor rule were enforced. Much depends on what numbers are put into his formula. Under the original calculation, Taylor’s rule says the Fed’s benchmark rate should be about 3.75 percent, compared with the 1 percent to 1.25 percent the central bank is now targeting. Revising down some of the inputs, such as allowing for a lower jobless rate at which inflation materializes, brings the rule closer in line with current Fed policy.

3. What is the rule’s track record?

Since 2012, applying the rule would have meant higher rates than those set by the Fed. Taylor himself, in 2011, said the Fed "would be better off" if it raised rates. But higher rates since 2012 could have been a mistake because inflation has lagged and remains well under the central bank’s 2 percent target. (Last January, Taylor said the Fed “is a little behind the curve.”) The rule isn’t always more hawkish than the Fed. When rates went to zero in 2008, during a recession, the rule recommended going further still and offering negative interest rates to jolt lending and spending. At the time, policy makers worried that such a move would harm the nation’s banks and prompt a public and political backlash.

4. Isn’t this just an academic debate?

Not at all. Lawmakers critical of the Fed’s easy monetary policy frequently cite the Taylor rule. For example, legislation championed by Texas Representative Jeb Hensarling, chairman of the House Financial Services Committee, includes a provision that would require the Fed to follow a policy rule, and then explain any deviation from the rule to Congress. Taylor, 70, has backed such a demand, writing in 2015 that “world monetary policy now seems to have moved into a strategy-free zone.”

5. What do central bankers think of a policy rule?

The response of many economists and policy makers is to say that such a requirement would curb the central bank’s independence, reduce its scope to maneuver and hurt the economy. When Congress, in 2015, considered legislation that would have required the Fed to adopt a rate-setting mathematical formula, Fed Chair Janet Yellen said it “would be a grave mistake, detrimental to the economy and the American people.” The Minneapolis Fed reckoned last year that pursuing the Taylor rule for the previous five years would have prevented the creation of 2.5 million jobs.

6. How does Taylor respond to criticism of his rule?

He’s always said the rule is a guideline, not a mechanical tool, meaning the Fed could deviate from what it prescribes. He just believes there should be a good reason to do so. “It is not that we want to tie central banker’s hands as much as we want a policy that works well, and that is the case when a clear strategy is in place,” he wrote in a recent paper. Former Fed Chairman Ben Bernanke has argued that a modified Taylor rule “pretty well described” what the Fed has done since the 1990s, though he also says that “monetary policy should be systematic, not automatic.”

7. Would Taylor follow the rule if he ran the Fed?

He might not have much of a choice but to be pragmatic. The chair of the Federal Open Market Committee has only one vote on policy, after all, and since Bernanke’s time at the helm, consensus has been the standard for decision-making. Fed policy maker Eric Rosengren recently said that “most people who end up being the chair, no matter who they are, tend to be a little bit more flexible in their thinking when they’re actually making the decision.”

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