Policy rate ceiling and Taylor’s Rule

Policy rate ceiling and Taylor’s Rule. Taylor’s Rule is a formula that links a central bank’s policy rate to inflation and economic growth. Developed by economist John Taylor in 1993, this rate assumes an equilibrium federal funds rate of 2% above the annual inflation rate.

The Taylor Rule adjusts the equilibrium rate based on the deviation from the central bank’s targets in inflation and real GDP growth. Exceeding inflation and growth targets raise the policy rate under the Taylor Rule, while reducing the deficits.

The basic Taylor Rule formula does not take into account the ineffectiveness of negative interest rates or alternative monetary policy instruments such as asset purchases. The Taylor Rule formula makes inflation the single most important factor in setting rates, while the Fed has a dual mandate to promote stable prices and maximum employment.

Taylor rule specification… Source: Federal Reserve Bank of St. Louis, FOMC “Statement on Longer-Run Goals and Monetary Policy Strategy

The Taylor equation, in its simplest form, looks like this:

r = p + 0.5y + 0.5(p – 2) + 2

Variables:

r = nominal federal funds rate

p = inflation rate

y = percent deviation between current real GDP and the long-run linear trend in GDP

The equation assumes an equilibrium federal funds rate of 2% above inflation, represented by the sum of p (inflation rate) and the rightmost “2”.

Taylor-type rules have been evaluated in a large literature and it has been claimed that they characterize the near-optimal monetary policy in widely used macroeconomic models.

Restrictive enough territory… Source: Federal Reserve Bank of St. Louis, Bureau of Economic Analysis, Bureau of Labor Statistics, Federal Reserve Bank of Dallas, Federal Reserve Bank New York

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