Evaluating the Current Stance of Monetary Policy Using a Taylor Rule

Evaluating the Current Stance of Monetary
Policy Using a Taylor Rule
Marc Labonte
Specialist in Macroeconomics
Government and Finance Division
Summary
Oversight of the Federal Reserve’s (Fed’s) monetary policy decisions rests with
Congress. But oversight is encumbered by the absence of a straightforward relationship
between interest rates and economic performance. Further, the Fed’s policy decisions
are discretionary, meaning there is no objective, transparent “yardstick” for evaluating
their decisions. A simple rule of thumb guide to monetary policy decisions called a
“Taylor rule” is an intuitive way to judge actual policy against some objective, albeit
simplistic, ideal. Taylor rules can be adjusted to reflect a variety of policy goals. This
report compares current policy to a number of Taylor rules, and finds that actual interest
rates are currently lower than the rules would prescribe because of the Fed’s decision to
sharply reduce rates to protect against a potential recession despite rising inflation.
The government has two main tools for influencing overall economic conditions,
fiscal policy and monetary policy. Monetary policy can boost economic activity and
inflation by lowering short-term interest rates (the federal funds rate), or depress
economic activity and inflation by raising interest rates. Changes in output and
employment caused by monetary policy are of a temporary nature: in the long run,
changes in the money supply affect only inflation and have no effect on the economy’s
sustainable growth rate. In essence, monetary policy has two attainable goals: to promote
economic stability (minimize fluctuations in the business cycle) and price stability (low
and stable inflation). Because the Fed has only one tool at its disposal, influence over
interest rates, it faces a tradeoff in the pursuit of these two goals — when the two goals
conflict, they cannot both be pursued at once.¹
Congress has delegated responsibility for monetary policy decisions to the Federal
Reserve, but maintains oversight responsibilities. Oversight is made difficult, however,
by the absence of a straightforward relationship between interest rates and economic

¹ For more information, see CRS Report RL30354, Monetary Policy and the Federal Reserve:
Current Status and Conditions, by Marc Labonte and Gail Makinen.

performance. Because of changes in investment demand, any given interest rate may be
expansionary when the economy is booming, but contractionary when the economy is in
recession. Furthermore, the Fed’s policy decisions are discretionary: it justifies policy
decisions qualitatively rather than quantitatively. Its decisions to change interest rates
need only be consistent with the broad mandate that it maintain full employment, stable
prices, and moderate interest rates. When these goals are mutually exclusive, as they
frequently are, the mandate can be used to justify virtually any policy decision. In this
context, Congress frequently finds itself in a position where it must “take the Fed’s word
for it” that the policy change will have the effect it is said to have because there is no
objective outside “yardstick” to evaluate it. This report attempts to offer such a yardstick.
One way to evaluate Fed policy for oversight purposes would be to use complex
econometric models to generate predicted results of a monetary policy change, and see if
these results conform with the policy change’s stated or mandated goals. But this requires
sophisticated knowledge of econometric modeling that may not be practical for oversight,
particularly since different models yield significantly different results. This report uses
a simpler, popular alternative called a “Taylor rule” to quantitatively evaluate the current
stance of monetary policy.² Economist John Taylor, recently a Treasury Undersecretary,
proposed the following rule to set interest rates that balances the goals of maintaining
economic stability and price stability:³
FFR = (R + I) + 0.5 x (output gap) + 0.5 x (I - IT)
where:
FFR = federal funds rate
R = equilibrium interest rate (assumed here to equal 2)
output gap = percent difference between actual GDP and potential GDP
I = inflation rate
IT = inflation target (assumed here to equal 2)
The goal of maintaining economic stability is represented by the factor 0.5 x (output
gap), which raises interest rates when actual GDP is greater than potential GDP and
lowers rates when it is below potential. The output gap is the difference between actual
and potential GDP. Potential GDP is the level of output that would be produced if all of
the economy’s labor and capital resources were being utilized; in economic downturns,
actual GDP falls below potential because some resources are idle. Likewise, because
prices adjust slowly, the economy can temporarily be pushed above a level of output that
is sustainable. Once prices adjust, output will return to potential. There is no direct way
to measure potential GDP, so it must be inferred; different estimating methods yield⁴
different results. This Taylor rule states that when actual GDP is, say, 1% above

² For background and analysis of Taylor rules, see CRS Report RL31050, Formulation of
Monetary Policy by the Federal Reserve: Rules vs. Discretion, by Marc Labonte.
³ John Taylor, “Discretion vs. Policy Rules in Practice,” Carnegie-Rochester Series on Public
Policy, vol. 39, 1993, p. 195; Robert Solow and John Taylor, Inflation, Unemployment, and
Monetary Policy (Cambridge, MA: MIT Press, 1998), p. 45. The specific mathematical form of
this rule does not appear to be formally derived from theory or empirical evidence.
⁴ This report uses CBO’s estimate of potential GDP. See Congressional Budget Office, CBO’s
(continued...)

potential GDP, the federal funds rate should be increased by 0.5 percentage points. If
policymakers wanted a more (less) aggressive reaction to changes in growth, they would
place a larger (smaller) weight on the coefficient than 0.5.
The goal of maintaining price stability is represented by the factor 0.5 x (I-IT), which
states that interest rates are to be raised when inflation (I) is above its target (IT) and
lowered when inflation is below its target. Unlike the output gap, the inflation target can
be any rate that policymakers desire. This rule assumes a 2% inflation target, which is
close to the 1994-2003 average of 1.8%, as measured by the GDP deflator. (As measured
by the consumer price index (CPI), the 10-year average inflation rate was 2.5%.) This
rule weights the response to deviations from the inflation target equally to deviations from
potential GDP: a one percentage point increase in inflation above its target would lead to
a 0.5 percentage point increase in the federal funds rate. If actual GDP is equal to
potential GDP and inflation is equal to its target, the rule calls for an inflation-adjusted
federal funds rate of 2%, or an actual federal funds rate equal to 2% plus the current
inflation rate. This is often called the “neutral” interest rate, at which monetary policy is
neither stimulative nor contractionary.
Current Policy Prescriptions According to Different Taylor Rules
In the first quarter of 2008, actual GDP was 1.6% below potential GDP and inflation
(using the GDP deflator) equaled 2.7% over the previous four quarters. Entering these
data into the Taylor rule above (and rounding to the nearest quarter point) yields a federal
funds rate of (2% + 2.7%) + 0.5 x (-1.6%) + 0.5 x (2.7% - 2%) = 4.25%, higher than the
current rate of 2%. With inflation at 2.7%, the current neutral rate is 4.75%, according
to the rule. The Taylor rule calls for an interest rate below the neutral rate because the
size of the output gap outweighs the increase in inflation above its presumed target. Since
this rule considers only current inflation and the output gap, it cannot consider other
factors that counsel against tightening policy, such as the potential for financial turmoil
since August 2007 to slow growth.⁵
Figure 1 plots actual federal funds rates against rates determined by the Taylor rule
from 1998 to 2003. This figure should not be used to directly evaluate actual policy for
two reasons. First, because economic data are released with a lag and subject to
subsequent revisions, Figure 1 is based on data unavailable to the Fed when actual policy⁶
decisions were made. Second, since subsequent events would have differed had a

⁴ (...continued)
Method for Estimating Potential Output, August 2001.
⁵ A major drawback to Taylor rules is that they cannot cover all contingencies. For example, in
times of crisis, the other function of monetary policy, to serve as a lender of last resort, could not
be adequately incorporated in a rule. Arguably, the Fed’s more aggressive stance in 2001 than
the rule would suggest was partly motivated by the unique circumstances surrounding September

11, which a rule cannot take into account. On the other hand, some economists argues that,

because of uncertainty over the proper way to model economic activity, simple rules perform
more robustly than complex rules across different models.
⁶ Athanasios Orphanides, “Monetary Policy Rules Based on Real-Time Data,” Federal Reserve
Board of Governors, Finance and Economics Discussion Series 3, 1998.

different monetary path been followed at any given point, the chart cannot be interpreted
as a consistent alternative policy option over time.
As can be seen in Figure 1, while interest rates under this rule followed the same
general pattern as actual rates — monetary tightening in the 1990s followed by easing in
the 2000s — there were some short-term differences. The rule called for lower interest
rates in 1998 because inflation was below the target. The rule called for similar interest
rates in 1999-2000, but a less aggressive policy response to the economic downturn that
began in 2001. (If the rule was based on data available at the time, the rate reduction
would have been even smaller since the GDP data have since been revised downward.)
This rule would have tightened policy slightly in the second half of 2003 as the economy
picked up speed, rather than leaving interest rates at 1% as the Fed did.
Figure 1. Federal Funds Rate, Actual and Prescribed by Taylor Rule,

1998-2003

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¹⁹^98-^I¹⁹⁹⁹^-^I²⁰⁰⁰^-^I²⁰⁰¹^-^I²⁰⁰²^-^I²⁰⁰³^-^I
ActualTaylor rule
^Source:^C^R^S^cal^cu^l^a^tⁱ^oⁿ^s^bas^e^{d on}^F^e^deral^R^e^s^e^rv^{e, BEA}^,^C^B^O^dat^a^.
The Taylor Rule used so far is one out of an unlimited number of possibilities. It is
useful to see in Table 1 how other rules based on different policy goals compare to
current policy. For example, economist Lars Svensson argues that since monetary policy
affects the economy with a lag, if policy is based on current data it will always be
backward looking, and “fighting the last war.” Since policy decisions made today affect
future economic conditions, he argues they should be based on projections of future
growth and inflation.⁷ Of course, different forecasters have different projections of future
growth, but this problem can be mitigated by using the Blue Chip “consensus forecast.”
Blue Chip is a private company whose monthly consensus forecast is the average forecast
of 50 different private sector forecasters. Based on the June 2008 consensus forecast,
GDP one year from now is projected to be 3.0% below potential GDP and inflation will
⁷ Lars Svensson, Inflation Forecast Targeting: Implementing and Monitoring Inflation Targets,
National Bureau of Economic Research, Working Paper no. 5797, October 1996.

fall to 2.3%. Using this data, a rule with the same weights as the “Traditional” Taylor rule
above calls for a current federal funds rate of 3%. Of the Taylor rules considered, this one
prescribes the lowest interest rates, because forecasters believe that growth will remain
sluggish (moving the economy further below full employment) and inflation will fall,
despite its recent rise.
Table 1. Current Policy According to Various Taylor Rules
^Ty^pe^o^f^R^u^le^F^e^dera^{l F}^{unds Ra}^t^e⁼^{Current I}ⁿ^teres^t^Ra^t^e^P^redict^e^{d by}
^{(See tex}^t^{for details}⁾^{Rule (}^A^ct^ua^l=2^%⁾
^T^r^ad^itioⁿ^a^{l T}^a^y^l^o^r^Ru^le⁽²^+I⁾^{+ 0}^.⁵^x⁽^o^u^t^p^u^{t g}^a^p⁾^{+ 0}^.⁵^x⁽^I^-²⁾⁴^.²⁵^%
^T^a^y^l^{or R}^u^{le bas}^e^{d on}^f^o^recas^t⁽^{2+I) + 0.5 x}^(ou^t^pu^{t g}^a^p^pr^o^j^{) + 0.5 x}^(I^pr^o^j^.^-2⁾³^%
^“^S^t^rⁱ^c^t^”^In^f^l^atⁱ^oⁿ^T^a^rg^et^{(2+I) + 1.0 x}^(I-²⁾⁵^.25%
^“^Fⁱⁿ^{e t}^uⁿⁱⁿ^g^”^T^a^y^l^{or R}^u^l^e^{(2+I) + 1.0 x}^(ou^t^pu^t^g^a^{p) + 1.0 x}^(I-²⁾^3.75%
^T^a^y^l^{or R}^u^l^e^bas^e^{d on}^hⁱ^s^t^ory⁽^{2.2+I) + 0.8 x}^(ou^t^pu^t^g^a^{p) + 0.5 x}^(I-²⁾^4%
^S^o^u^rce:^C^R^S^c^a^l^c^u^la^tions^ba^s^e^{d on qua}^r^t^e^r^ly^da^ta^f^r^om^B^E^A^,^Fe^de^r^a^{l R}^e^s^e^r^v^e^,^C^B^O^{, B}^l^ue^C^h^ip.
^Note:^FFR⁼^f^e^de^r^a^l^f^unds^r^a^te^;^output^g^a^p⁼^pe^r^c^eⁿ^{t dif}^f^e^r^e^nc^e^be^tw^e^eⁿ^a^c^t^ua^{l G}^D^P^a^{nd pote}ⁿ^tia^{l G}^D^P^;^I⁼^inf^l^a^tion
^r^a^te^{, m}^e^a^s^ur^e^d^by^G^D^P^de^f^l^a^t^or^{. R}^e^s^u^lts^a^r^e^r^ounde^{d to ne}^a^r^e^s^{t qua}^r^t^e^r^point.
Making price stability the sole goal of monetary policy (inflation targeting) has been
widely implemented abroad in economies such as the United Kingdom and the euro area,^th
and bills to switch to inflation targeting have been introduced in the 110 Congress (H.R.
6042, H.R. 6053).⁸ Proponents support inflation targets for three reasons related to this
report. First, many economists have reservations with “fine tuning” in monetary policy.
Since the Fed can make mistakes and markets can (eventually) adjust on their own, they
argue that the best monetary policy is a “hands off” one that does not try to respond to
every small change in the economy. Second, some economists have argued that monetary
policy should focus less on stabilizing output since only the inflationary effects of
monetary policy are permanent. Third, in the context of a Taylor Rule, a strict inflation
target could be justified on the grounds that measurements of the output gap are too
uncertain to be useful (as discussed below).⁹
To see how a “strict” inflation target would operate, the traditional Taylor rule can
be adapted by removing the output gap and increasing the weight on the inflation target
to, say, 1.0. Under this rule, the current interest rate would equal 5.25% — above the
neutral rate because inflation is 0.7 percentage points above its presumed target. When
inflation does not follow the business cycle closely, a strict inflation target rule causes
monetary policy to become less counter-cyclical, and this rule would not have followed
actual policy very closely recently. As practiced by inflation targeters abroad, monetary
policy has still attempted to stabilize economic growth, usually under the rationale that

⁸ See CRS Report 98-16, Should the Federal Reserve Adopt an Inflation Target?, by Marc
Labonte and Gail Makinen.
⁹ Bennett McCallum, Should Monetary Policy Respond Strongly to Output Gaps?, National
Bureau of Economic Research, Working Paper no. 5952, April 2001.

stable growth helps maintain stable prices.¹⁰ Therefore, the strict inflation target used here
does not reflect international experience with inflation targeting.¹¹ Alternatively,
policymakers may prefer a more aggressive response to changes in economic conditions
— more “fine tuning” — than the traditional Taylor Rule provides. More fine tuning can
be incorporated by raising both coefficients on the original rule from 0.5 to, say, 1.0.
When this change is made, the current interest rate would be 3.75% (see Table 1).
As has been discussed, there are an unlimited number of weights that can be placed
on the inflation and output factors because there are an unlimited variety of policy
preferences. Rather than arbitrarily assigning a set of preferences to the Taylor rule,
another approach is to determine what weights best parallel actual Federal Reserve policy
historically. Taylor does this in a 1999 paper and shows that a Taylor rule has a high
goodness of fit (the R-squared is 0.83 and the coefficients are highly statistically
significant) in the Greenspan era.¹² In other words, most of the decisions that the Fed
made in the Greenspan era through the third quarter of 1997 are the same as if the Fed had
been following a Taylor rule; this is reassuring for the use of Taylor rules to aid oversight.
The “historical” Taylor rule turns out to have similar weights to the “traditional” one
suggested by Taylor: the weight on the output gap would be raised from 0.5 to 0.8 and the
weight on inflation would remain 0.5. The real equilibrium interest rate is slightly higher
in this period (2.2%) than assumed in the original Taylor rule (2%). A comparison of
current interest rates and those predicted by this “historical” Taylor rule can be interpreted
as showing whether current monetary policy decisions are similar to ones taken by the Fed
in the past. If the Fed had continued its historical behavior, interest rates would have
tended to be higher than they actually were recently, and interest rates would currently be

4% (see Table 1).

One drawback to evaluating monetary policy using a Taylor rule is that the policy
prescriptions made by the Taylor rule are very sensitive to the choice of data sources and
coefficient weights. In particular, since the output gap is a constructed series that can be
estimated using a number of different methods, different output gap series produce widely
different results. Likewise, there are several equally valid measures of inflation available,
and sometimes these series diverge for short periods of time. Kozicki shows that different
data sources can change the Taylor rule’s recommended interest rate by as many as
several percentage points.¹³ Discretionary policy is able to weigh conflicting data in a
way that a rule cannot. Nevertheless, discretionary policy still must be based on the same
conflicting data as rules, so this advantage should not be overestimated.

¹⁰ The output gap might not be removed if future (rather than current) inflation were targeted
under a strict inflation target. In that case, the rule might still react to changes in the output gap
in so far as changes in the output gap affect future inflation. See Laurence Ball, Efficient Rules
for Monetary Policy, National Bureau of Economic Research, Working Paper no. 5952, March

1997.

¹¹ See CRS Report RL31702, Price Stability (Inflation Targeting) as the Sole Goal of Monetary
Policy: The International Experience, by Marc Labonte and Gail Makinen.
¹² John Taylor, “A Historical Analysis of Monetary Policy Rules,” in John Taylor, ed., Monetary
Policy Rules (Chicago: University of Chicago Press, 1999), p. 319.
¹³ Sharon Kozicki, “How Useful are Taylor Rules for Monetary Policy?,” Federal Reserve Bank
of Kansas City Economic Review, vol. 84, no. 2 (1999:2), p. 5.