The Taylor Rule
With the upcoming FOMC meeting and as always the speculation of what might happen to interest rates I have decided to give you something to think about. The Taylor Rule is something that all good Fundamental Analysists use to project where the Fed might move rates.
What is the Taylor rule?
Central bankers consider a wide range of variables and economic indicators when setting interest rates. Essentially however, all central banks have the same basic objectives-economic growth running at potential and inflation on target at some specified level. Thus, despite all the data on hand, there exists a relatively simple rule, the Taylor rule, that does a good job of estimating the path of interest rates. Stanford economist John Taylor, currently the Under Secretary for International Affairs at the Treasury Department, formulated the Taylor rule.
How is it calculated?
The rule states that central banks can conduct effective monetary policy by focusing on two variables: 1) the difference between actual and target inflation and 2) the difference between actual and potential GDP growth (also known as the output gap). Under the Taylor rule, the Fed funds rate can be determined as follows:
Fed funds rate = Inflation + 0.5*(Output gap) + 0.5*(Difference between actual and target inflation) + Equilibrium real rate (assumed to be 2-3%)
Following this rule, the Fed should raise rates when inflation is above target or when GDP growth is too high (above potential). Similarly, the Fed should ease rates when inflation is below the target level or when GDP growth is too slow (below potential). When inflation is on target and GDP is growing at potential, policy rates are said to be at a neutral level. The important point to note from the Taylor rule is that in order to suppress inflation, interest rates need to rise by more than any increase in inflation.
Why is the Taylor rule important?
Because the dollar trades to some extent according to interest rate expectations, having a basic understanding of the Taylor rule gives traders valuable insight into the Fed’s interest rate decisions. Indeed, over the past eight years the Taylor rule has reasonably approximated the path of the Fed funds rate. Some observers go so far as to note that in recent history the Fed has implicitly followed this rule in setting monetary policy. More importantly, financial markets appear to be convinced of this, as reflected in expectations of inflation over the past decade.
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