Checking in on the Taylor Rule and the Fed

July 13th, 2013 at 10:58 am

Given the recent confusion as to the Federal Reserve’s current stance, it seems like a fine time for a quick look at the “Taylor rule.”  That’s an equation economists and Fed watchers like to use to see what the central bank’s federal funds rate ought to be given broad conditions in the macroeconomy.  The inputs to the rule are inflation and unemployment and its output is the expected fed funds rate. 

A relevant advantage to the rule at a time like this is that since it’s just an equation it’s not bound by zero (as are nominal rates).  The fact that it’s been negative since 2009 has been a strong motivator for the Fed’s alternative measures, like quantitative easing.

Before plotting the inputs, let’s think for a minute about what they’re probably saying.  Basically, unemployment is stuck a couple of percentage points above where it would be at full employment and inflation has been low and slow.  Those are trends associated with an economy asking for continued, not “tapered” monetary stimulus (fiscal too, of course, but Congress is beyond hopeless in this regard—they’re, i.e., House R’s—busy trying to kill food stamps).  Bernanke himself made similar points late last week.

As you can see in the figure below, inflation has been decelerating.  The line for unemployment in the figure is actually the unemployment gap, or the CBOs estimate of the unemployment rate associated with full employment minus the actually unemployment rate.  When that line hits zero, the economy’s at full employment, as per CBO at least.  It’s been consistently drifting up, a good thing for sure, but it’s still two big points below zero.


Source: BLS, BEA, CBO; The 2013q2 observation for inflation is from May13/May12, i.e., monthly data since the quarterly PCE deflator is not yet available.

Plug these values into the Taylor rule* and you get the figure below.  As the recovery has proceed it has drifted up, but it’s still a negative, implying that the zero-lower-bound on the federal funds rate is still a serious macroeconomic constraint on policy.  Moreover, it’s been camping out at between -1 and -2 percent for the past two years.


Source: See text

So, you look at those pictures and you can sort of see how the Fed might feel compelled to reasonably say, “Yo, markets…at some point things will have to start getting back to normal” though there are good questions as to whether the necessary uncertainty embedded in “at some point” is really worth getting skittish investors all lathered up over.

But given inflation’s deceleration and the still-large two point output gap,* you can also see an economy that’s clearly not ready to come off the medication.

*I used this version: 2+p+(0.5(p-2))+y where p is year-over-year percent change in the PCE inflation index and y is the output gap: 2*(nairu-unemp) where 2 is the Okun coefficient and the nairu is from CBO.

**Looking at Figure 1 above, close observers may wonder why inflation is slowing while the output gap is closing.  Shouldn’t a closing output gap be associated with faster price growth?  Isn’t that the whole basis of the NAIRU?  We’ve got to watch out for unemployment getting too low or it will lead to spiraling price growth!  Right??!!  Um…maybe not so much, especially in recent cycles.  But more on that some other time.

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11 comments in reply to "Checking in on the Taylor Rule and the Fed"

  1. foosion says:

    Mankiw’s version of the Taylor rule seems popular
    Federal funds rate = 8.5 + 1.4 (Core inflation – Unemployment)

    Tapering under current conditions seems insane.

  2. jonas says:

    Mr Bernstein-
    If I wanted to recreate this graph in FRED, could I plot “2+a+(.5*(a-2))+2*(b-c)” where a=PCEPI (percent change from a year ago), b=NROUST (percent), and c=UNRATE (percent)?

    I think something went haywire, because I did just that, and my line is rather similar to yours, but shifted up by about 1 percentage point. I use FRED quite a bit, but I’m not exactly a “power user.” Maybe the “2″s ought to be “0.02″?


  3. Perplexed says:

    -”…though there are good questions as to whether the necessary uncertainty embedded in “at some point” is really worth getting skittish investors all lathered up over.”

    U.S 10yr’s 2.58%; Japanese 10yr’s 0.82%. (Looks like you really have to go “over the cliff” to borrow cheaply these days). Good thing allot of the residential real estate demand is driven by large funds buying up cheap property to fix up and rent out or the increases in mortgage rates could be a real problem right?

  4. urban legend says:

    It’s hard to accept the notion that we would have anything remotely like full employment with an unemployment rate only two percentage points (or so) below the current rate. We have a U-6 over 14%, more than twice the rate when we really did have genuine full employment, including over eight million involuntary part-time workers, and with an employment-to-population ratio under 59% that represents excess unemployment and underemployment of roughly 15 million people.

    Where the black-letter unemployment rate is clearly an inappropriate measure of real unemployment, how much utility can there be in the Taylor Rule?

    • Jared Bernstein says:

      Point taken–your emp rate point is particularly germane given how the decline in labor force participation artificially reduced measure unemployment (including u-6).

  5. Bob Wyman says:

    Mankiw’s version of the Taylor rule went positive (0.08%) in March for the first time since 2008 but has been negative since March.
    Krugman’s version of the rule has been negative since 2008.

    Mankiw’s rule is the red line, Krugman is the purple one.

  6. Edward Lambert says:

    Mr Bernstein,
    The problem i have with the Taylor rule is the output gap. The potential real GDP cannot be reached because of the limit by effective demand, as related to Keynes’ concept of effective demand. The CBO says potential RGDP is above $14.6 trillion, but the limit from effective demand says the potential can only reach $14.1 trillion.
    When you are in business, you understand that your production can be limited by demand. You could produce more, but demand determines the potential of what you could produce. To set a potential production above demand would be misleading.
    In my data since 1967, this is actually the first time that we will see effective demand undercut the CBO’s projection of potential RGDP.
    With the present dynamics of much lower labor income, the economy will not be able to reach $14.6 trillion due to a constraint of effective demand. So using the CBO’s determination of potential RGDP is suspect and needs to be re-evaluated.

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