Taylor Rule

The Taylor Rule is a formula that tells central banks what interest rate to set based on how far inflation is from its target and how far output is from its potential. Named after economist John B. Taylor, the rule has become one of the most influential guides to monetary policy in the world, even though no central bank mechanically follows it.

The formula and what it means

The original Taylor Rule is simple: the federal funds rate should equal 2% (the neutral rate, roughly) plus 1.5 times the inflation gap (inflation minus target) plus 0.5 times the output gap (actual output minus potential). So if inflation is 1% above target (meaning inflation is running 3% and the target is 2%) and output is 1% below potential, the rule suggests a federal funds rate of 2 + (1.5 × 1%) + (0.5 × –1%) = 3%. The rule is remarkably stable in its prescriptions. Even with different data sources, the Taylor Rule’s recommended rate is usually within 50 basis points of where it would suggest for any given period.

Why it works as a communication tool

The Taylor Rule’s main contribution is not mechanical precision — it is transparency. By laying out a rule, the Federal Reserve (or any central bank) reveals what it thinks the interest rate should be based on observable economic data. When the Fed deviates from the Taylor Rule, observers ask why. Is the Fed reacting to financial stability risks the rule ignores? Is it trying to support a particular political outcome? Is there new information the rule’s creators didn’t anticipate? The rule thus becomes a reference point for debate. Even economists who think the Fed should deviate from it agree that knowing what the rule suggests is useful.

The big assumption: the neutral rate

The Taylor Rule’s biggest weakness is its dependence on the “neutral” or “natural” interest rate — the rate that neither stimulates nor constrains the economy. In the 1990s, economists thought the neutral rate was around 2–2.5%. Today, after decades of low inflation and slow growth, many think it is closer to 0.5–1%. This difference is enormous. If the neutral rate is 0.5% and inflation is 2%, a standard Taylor Rule might suggest a 2% federal funds rate. But if the neutral rate is really 2.5%, then 2% is much more restrictive. The rule’s sensitivity to this unmeasurable input means different versions of the Taylor Rule can suggest widely different rates for the same economic conditions.

Applications beyond the Fed

The Taylor Rule has become a reference point not just for the Federal Reserve but for other central banks. The European Central Bank and Bank of England have both been compared to Taylor Rule benchmarks. Some central banks have published their own versions tweaked to local conditions. And academics use it routinely to ask counterfactual questions: if the Fed had followed the Taylor Rule instead of its actual policy in 2003–2004 (keeping rates very low), would the housing bubble have been smaller? This empirical flexibility is both a strength and a weakness — different tweaks to the rule can justify almost any policy.

How the Fed has deviated from it

The Fed’s policy over the past 20 years has often been more accommodative than a standard Taylor Rule would suggest. In the aftermath of 2008, the Fed cut interest rates to zero and kept them there for seven years — far below what the Taylor Rule would suggest even accounting for the severe recession. In 2020–2021, the Fed again stayed below the Taylor Rule, keeping rates near zero even as inflation began to rise. Fed leadership argued that the unusual economic conditions (zero interest rates already below the effective lower bound) required judgment beyond the rule. Critics argued the Fed was behind the curve on inflation and should have followed the Taylor Rule more closely.

A tool, not a straitjacket

The Taylor Rule’s enduring value is as a diagnostic tool. It helps observers understand what “normal” monetary policy looks like and whether the current stance is unusual. But no serious economist argues the Fed should be enslaved to the formula. Economic conditions change, new risks emerge, and policymakers have information the rule ignores. The best central banks — including the Federal Reserve, Bank of England, and ECB — use the Taylor Rule as a signpost while exercising judgment about when and why to deviate from it.