The Taylor Rule And Interest Rates

Posted: Feb. 13, 2018, 10:48 a.m. by

Taylor Rule


Economist, John Taylor, came up with an interest rate forecasting model that became known as the Taylor Rule in 1992. The Taylor Rule came about as a reaction to rational expectations theory models like the Phillips Curve that attempted to forecast the trade-off between inflation and employment.

The problem with Phillips Curve was that it was backward-looking and didn’t consider long-term economic prospects. Models like the Phillips Curve sometimes worked in the short term but didn’t allow for economic adjustments when the interest rate action taken was wrong.

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Breaking Down The Taylor Rule

The formula for the Taylor Rule essentially says that the difference between a nominal and real interest rate is inflation. Real interest rates factor inflation. Nominal rates do not. This requires looking at the total picture of the economy in terms of prices.

Prices and inflation are driven by the consumer price index, producer prices and the employment index. With regard to the consumer price index, Taylor considers the whole consumer price index and not core CPI. That’s because core CPI does not include food and energy prices. Further Taylor recommends factoring the rate of inflation over a year to obtain a comprehensive picture.

Inflation And Interest

According to Taylor the real interest rate should be 1.5 times the inflation rate. He bases this on an equilibrium rate assumption that factors the real inflation rate against an expected inflation rate of about 2%.

There’s another way to view this. This way involves the coefficients on the deviation of real GDP from trend GDP and the inflation rate. Both ways work but make up only half of the equation. The other half is output.

Output

Output is determined by productivity, labor force participation and changes in employment. The Taylor Rule looks at real output against potential output. It looks at GDP in terms of real and nominal GDP (actual versus trend GDP). The formula calls for dividing nominal GDP by real GDP and multiplying this figure by 100. The answer is the figure for real GDP.

The product is 3 numbers: interest rate, inflation rate and a GDP rate. All are based on an equilibrium rate to gauge the proper balance for a forecast interest rate.

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Weaker Versus Stronger Dollar

At the end of the day, enforcing the Taylor Rule would result in higher interest rates and a stronger dollar. A weaker dollar is thought to provide a boost to exports and a short-term stimulation of the economy. A stronger dollar makes it more difficult for manufacturers to export resulting in cost cutting and layoffs of the labor force. The upside is that it forces companies to be more competitive with overseas players. In other words, a stronger currency can make domestic industries more efficient.

All this matters because if new Fed Chairman Jerome Powell decides to enforce the Taylor Rule, the result will likely be higher interest rates, a stronger dollar and the implementation of those negative factors mentioned above. Another result could be economic efficiency and real economic growth versus the artificial growth now – at least according to some voices.