Tuesday, June 30, 2015

The Taylor Rule

What Is The Taylor Rule and Why Do We Care?
The Taylor Rule is a formula that gives an indication of where we should expect the Fed to set the rate of Fed Funds in the future.  The formula takes into consideration the dual mandate of the Fed to control inflation and to promote maximum employment through healthy economic growth.  The reason we care about the Taylor Rule is that it is an indicator that the FOMC monitors as a guide for monetary policy.  There is currently considerable discussion about when the Fed will raise rates and how that will impact the bond market.  There is also disagreement about how the Fed should conduct monetary policy, and how the Taylor Rule should fit into their decision making process.

The Taylor/Bernanke Debate

John Taylor has been making the argument that the Fed should use the Taylor Rule as a benchmark for determining monetary policy.  Ben Bernanke recently argued on his Brookings Institute blog that while the Taylor Rule is a valuable device to be considered, “the FOMC should not be replaced with robots any time soon.”  Bernanke argued that even if the Taylor Rule is used as a benchmark, the variables that make up the formula are subject to debate and interpretation.

The Taylor Rule Formula

The formula for the Taylor Rule is shown below.  It states we should expect the Fed Funds rate to be equal to the neutral real rate plus the current level of inflation.  This number is then adjusted for both desired inflation (the inflation gap) and the growth rate of the economy.  Economic growth in this model is measured by the output gap.

Fed Funds = Neutral Real Rate + Inflation 
                     + [.50 × (Inflation – Target)] 
                     + [.50 × Factor × (NAIRU – Unemployment)]

Below is the Taylor Rule model in Bloomberg with John Taylor’s inputs in the amber fields.  The amber fields are variables which can be adjusted to determine what you think is appropriate.  This is a “Taylor Rule calculator.” 


This model is helpful in understanding the arguments for and against changing the Fed Funds rate.  For example, in this model there is an equal weighting to the inflation adjustment (0.50) and the employment adjustment (0.50), and the neutral rate is assumed to be 2.0%.  Using these inputs the formula calls for a Funds rate of 2.35% which is much higher than the current rate of 0.0%.  John Taylor would say the Fed is way too easy and the Funds rate should be raised to 2.35%.  Bernanke suggested the output gap should have a higher weighting (1.0) than the 0.50 weighting John Taylor used.  In addition, he used estimates prepared by the Fed staff and Congressional Budget Office for measuring the output gap.  Bernanke’s model showed the Fed Funds rate should be about 1.25%. 

Disagreement Among Economists

The model above can be changed in Bloomberg to incorporate the underlying assumptions of several different economists.  The table below shows these assumptions for the 6 different variables which are shown in the amber fields.    This table shows there is disagreement among economists in each one of the variables.

Adjustment for Policy Inertia

There is an extremely high correlation between what the next Fed decision is, and what their last decision was.  There has been little discussion about this in economic literature.  We have found that if we use a factor (Rho) of 0.75 to 0.90 we get an almost exact tracking of where the Fed Funds has been.  The current estimate for the Funds rate allowing for policy inertia is about 0.50%.  We feel this is representative of where the Funds rate should be.

Adjustment for Policy Inertia = [Rho x Previous Federal Funds Rate] 
                                                   + [(1 – Rho) x Taylor Rule Estimate] 


There seems to be little agreement about what assumptions should be used in determining the appropriate Fed Funds rate today.  This makes it difficult to argue for a significantly higher Funds rate than the current zero bound rate.  The Fed has undershot its inflation target for the last 5 years and economic growth has been below trend for this same period of time.  There has been significant chatter about when the Fed will raise the Funds rate.  We believe the focus should be on how high the Funds rate should be.  Fed Funds futures are calling for a rate of 0.32% by year end.  An increase of this magnitude should not have a meaningful impact on fixed income portfolios.

Below is a link to Ben Bernanke's original blog post about the Taylor rule: