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