Adapting the Taylor Rule for the Modern Economy
In a recent two-part Economic Synopses essay, economist Kevin Kliesen examines whether the Fed's recent monetary policy decisions align with the much-touted "Taylor rule" and presents St. Louis Fed President James Bullard's alternative version of the rule for setting the federal funds rate.
Part 1 explains the basic principles of the rule, originally published by economist John Taylor in 1993: The Fed should raise its federal funds target rate proportionally more when inflation increases; the interest rate should be adjusted according to the amount of "slack" in the economy; and the interest rate should remain steady at 2%, adjusted for inflation. Kliesen looks at the actual fed funds target rate from 2010 to the end of 2018 and notes that the Fed's actual rate is less volatile and significantly lower than the rate prescribed by the rule.
Part 2 gives an overview of James Bullard's "modernized" Taylor rule. This alternative version of the rule substitutes updated measures for key concepts in Taylor's equation to account for changes in the macroeconomy since the early 1990s—particularly lower short-term real interest rates, the disappearing Phillips curve, and better measures of inflation expectations. Bullard's variant rule emphasizes "smoother" changes in policy rates by placing greater emphasis on the rate's recent value, and allows the interest rate to vary from the fixed 2% of Taylor's rule.