What it means
Taylor introduced his rule in 1993 as a description of how the US central bank had behaved in the years before. It linked the policy interest rate to two things: how far inflation was from its target, and how far the economy was running above or below its normal capacity.
The rule is simple enough to use on the back of an envelope. When inflation rises above target or the economy overheats, the rule says rates should go up.
When inflation is low or the economy has a lot of spare capacity, it says rates should come down. A key feature is that interest rates should rise by more than the increase in inflation.
This is often called the Taylor principle, and it ensures that the real interest rate (the rate after removing inflation) rises when prices are heating up. Without it, higher inflation could simply push real borrowing costs down and fuel more spending.
For businesses and finance teams, the Taylor Rule is a handy benchmark. If the central bank's actual rate is well below what the rule suggests, you may expect rates to rise, and the reverse is also true.
Lenders, treasurers and analysts compare actual rates with the rule to gauge the stance of policy. The rule has limits.
It depends on estimates of the neutral interest rate and the output gap (the difference between actual and potential output), both of which cannot be seen directly and are often revised. Central banks also look at many other things, including financial stability and employment, so they do not follow it mechanically.
Taylor has also been active in policy debates and served as a senior official in the US Treasury, working on international economic affairs. His writing argues that clear, predictable rules for policy lead to better economic outcomes than constant improvisation.
In practice
Real-world examples.
Example
A corporate treasurer in a manufacturing firm sees inflation running above target and the economy growing strongly. She uses a Taylor Rule estimate to judge that interest rates are likely to rise, so she fixes the rate on part of the company's floating-rate loan.
Example
A property developer wonders whether the central bank is behind the curve. His bank's economist shows that the actual policy rate sits two points below the Taylor Rule figure, which suggests rate increases may follow and that he should test his project returns at higher financing costs.
Example
A university lecturer asks her students to calculate the Taylor Rule rate using published inflation and growth data. The students learn how a small change in the output gap or the inflation target changes the answer.
Formula
Calculation
Taylor Rule: Policy rate = Neutral real rate + Inflation + 0.5 x (Inflation - Target inflation) + 0.5 x Output gap
All figures are in per cent. Suppose the neutral real rate is 2%, inflation is 3%, the target is 2% and the economy is running 1% above its potential.
Policy rate = 2% + 3% + 0.5 x (3% - 2%) + 0.5 x 1%
Policy rate = 2% + 3% + 0.5% + 0.5% = 6.0%
The rule suggests a policy rate of 6.0%. If the central bank's actual rate were 4.0%, a business could read that as a hint that borrowing costs might rise, and plan its loan repayments and pricing accordingly.Case study
Seen in the real world.
This is a fictional illustration. Corvid Housing, an invented residential builder, had a large loan with a floating interest rate and was planning a new estate. Its finance director, Naledi, wanted to know where rates might be heading.
She used a simple Taylor Rule calculation with current inflation, the central bank's target and an estimate of the output gap. The result was a rate nearly two points above the actual policy rate, a sign that the central bank might tighten.
Naledi converted half of the loan to a fixed rate and built a stress test showing the project's profit at a rate 2% higher. When rates did rise over the following year, Corvid's interest cost was lower than it would have been, which in this fictional story kept the project on budget.
Watch out
Common mistakes.
- Treating the Taylor Rule as a forecast. It describes what a rule-based policy would suggest, not what the central bank will actually do.
- Using different inputs without saying so. Changing the neutral rate or the output gap estimate can move the answer by several points.
- Assuming Taylor invented central banking rules for all countries. The rule is a guide that can be adapted, not a law that every bank follows.
Questions
People also ask.
What is the Taylor Rule in simple terms?
It is a formula that suggests the right policy interest rate based on inflation and how strong the economy is.
Who is John Taylor?
He is a Stanford economist who introduced the rule in 1993 and has also served in senior US government roles.
What is the Taylor principle?
It says that the central bank should raise nominal interest rates by more than the rise in inflation, so that real rates increase.
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