Balanced-Approach Rule vs Taylor Rule

The balanced-approach rule vs Taylor rule comparison highlights two competing frameworks for setting the federal funds rate. The original Taylor rule weights employment gaps and inflation deviations equally; the Fed’s balanced-approach rule gives equal weight to the gap between actual and maximum employment, making it more responsive to slack in the labor market. During a recovery with falling unemployment but persistent inflation, these different weightings prescribe markedly different rate paths.

Origins and design

John Taylor published his rule in 1993 as a simplified guideline for central banks. His formula was:

Fed funds rate = 2% + inflation + 0.5 × (inflation gap) + 0.5 × (output gap)

Where:

• The inflation gap is actual inflation minus the 2% target.
• The output gap is the percentage difference between actual and potential GDP.

The rule was elegantly simple: raise rates by 0.5 percentage points for every 1% the output gap widens (the economy overheating) and 0.5 points for every 1% inflation overshoots its target. The dual mandate was built in equally.

The balanced-approach rule, adopted by the Federal Reserve in its 2020 policy review, modified this framework:

Fed funds rate = longer-run neutral rate + inflation + 0.5 × (inflation gap) + 0.5 × (employment gap)

The substitution is crucial. Instead of output gap, the balanced-approach uses the employment gap—the shortfall of actual unemployment from the natural rate of unemployment—and weights it equally with the inflation gap.

Why the employment gap versus output gap?

The original Taylor rule relied on the output gap, measured as actual GDP relative to potential (non-inflationary) GDP. Potential GDP is difficult to estimate in real time. Economists disagree about whether current unemployment is above or below the natural rate, but measuring the gap is more tractable than estimating unobservable potential output.

The Federal Reserve’s switch reflected two practical lessons:

1. Real-time estimation is unreliable. Potential output estimates are revised substantially over time, leading to policy mistakes.
2. Labor market performance is more directly observable. Unemployment is measured monthly and with less revision than GDP estimates.

By centering the rule on the employment gap—the degree to which unemployment sits below the Fed’s estimate of the natural rate—the rule becomes more forward-looking and less dependent on erratic GDP estimates.

Comparing prescriptions: a worked example

Suppose the economy is recovering from a recession. Inflation is 3%, unemployment is 5%, the Fed’s inflation target is 2%, and it estimates the natural rate of unemployment at 4.5%.

Under the Taylor rule:

• Inflation gap = 3% − 2% = 1%
• Output gap (assumed) = −1% (economy still below potential)
• Fed funds rate = 2% + 3% + 0.5 × (1%) + 0.5 × (−1%) = 5%

Under the balanced-approach rule:

• Inflation gap = 3% − 2% = 1%
• Employment gap = 5% − 4.5% = 0.5% (0.5 percentage points of slack)
• Assuming a longer-run neutral rate of 2.5%:
• Fed funds rate = 2.5% + 3% + 0.5 × (1%) + 0.5 × (0.5%) = 6.25%

Wait—in this example, balanced-approach calls for a higher rate. The reason: the employment gap is positive (unemployment is above the natural rate), indicating slack, whereas the output gap was negative. But if unemployment were below the natural rate—say, 4%—then:

Balanced-approach revision (unemployment = 4%):

• Employment gap = 4% − 4.5% = −0.5% (overheating)
• Fed funds rate = 2.5% + 3% + 0.5 × (1%) + 0.5 × (−0.5%) = 5.25%

Here, the balanced-approach rule prescribes a lower rate than the Taylor rule because the rule penalizes overheating in employment directly.

How the rules diverged in practice: 2021–2022

The real-world divergence came during the post-pandemic recovery. By mid-2021, inflation had risen to 4%–5%, but unemployment remained elevated at 5%–5.5%. The Fed’s estimates of the natural unemployment rate ranged from 3.5% to 4%, implying substantial labor market slack.

Under a Taylor rule (with output gap estimates), the economy appeared not yet fully recovered, so the rule suggested rates should rise more slowly.

Under the balanced-approach rule, the employment gap was still positive (unemployment above the natural rate), suggesting the same: more gradual hikes appropriate given persistent slack.

By late 2021 and early 2022, unemployment dropped sharply—first to 4.2%, then to 3.5%—while inflation continued upward. Now:

Taylor rule (with revised output gap estimates showing the economy near or above potential):

• Calls for more aggressive rate hikes, approaching 4%–4.5% by mid-2022.

Balanced-approach rule (with unemployment now below the natural rate estimate):

• Also calls for more aggressive hikes, but the path might differ because the employment gap now represents overheating.

The Fed’s actual behaviour in 2022—raising rates 75 basis points in three consecutive meetings, then more slowly—aligned more closely with forward-looking assessments of the employment gap than with real-time output gap estimates, suggesting the balanced-approach framework was influencing decisions even before explicit methodology shifts.

Symmetric treatment of slack and overheating

A subtler distinction: the balanced-approach rule treats labor market slack symmetrically. A 0.5-percentage-point excess of unemployment (slack) reduces the implied rate by 0.25 percentage points; a 0.5-percentage-point shortfall (overheating) raises it by 0.25 percentage points.

The Taylor rule applies the same symmetry to output gaps, but the measurement of output gaps is noisier. Some critics argue that using the employment gap makes the rule more responsive to actual economic tightness, while others counter that ignoring the output gap misses important dynamics in capital productivity, labor productivity, or asset prices, which the output gap traditionally captures.

Criticisms and alternatives

Against the balanced-approach rule:

• It ignores the output gap entirely, missing signals from financial conditions, asset inflation, or capacity utilization.
• The natural rate of unemployment is itself difficult to estimate and revised frequently.
• It may over-respond to temporary labour force swings (retirements, migration) that are not truly deflationary.

Against the Taylor rule:

• Real-time output gap estimates are unreliable and subject to large revisions.
• It was calibrated in a different era (1990s); neutral rates and trend growth have shifted.

Alternatives in practice:

• Many central banks use model averaging, weighting multiple rules and models rather than committing to one.
• The European Central Bank and Bank of England employ broader dashboards of indicators.
• Some economists propose time-varying neutral rates and time-varying natural unemployment to improve real-time accuracy.

Current Fed practice

Since 2020, the Federal Reserve has stated that the balanced-approach rule informs its thinking, but it does not follow it mechanically. Forward guidance and monetary policy decisions reflect a broader set of factors—asset prices, financial conditions, long-term inflation expectations, and near-term developments. The rule serves as a starting point and consistency check, not a rigid formula.

The choice between frameworks remains contested among academics and policymakers, and future shifts in methodology are possible as more experience accumulates with each approach.

See also