Latest / Monetary Policy Explained with Fexingo: Central Banks, Money Supply, and Interest Rates / How Central Banks Use the Taylor Rule
Transcript
- Lucas: So you've got inflation at, say, three percent, the economy running a bit below potential — what should the central bank do with interest rates? There's actually a formula for that. Luna: You're talking about the Taylor Rule, aren't you? Lucas: Exactly. It's one of the most famous — and most debated — tools in monetary economics. And it's remarkably simple on paper. Luna: Before we dig into the algebra — and I promise we'll keep it light — I want to mention something. If walking through the economy with us every week has made something click for you, we keep this show ad-free thanks to listeners who support us over at buy me a coffee dot com slash fexingo. It's a small way to keep the conversation going. Lucas: Yeah, and it really does make a difference. So — back to the Taylor Rule. John Taylor, a Stanford economist, published the original version back in 1993. Luna: And the idea was to capture how the Fed had actually been setting rates in the 1980s and early '90s. It was descriptive at first. Lucas: Right. The rule says the federal funds rate should equal one point five times the inflation rate plus zero point five times the output gap, plus one. So if inflation is two percent and output is at potential, you get four percent. Luna: That's the famous 'neutral rate' of four percent from the original paper. But today, r-star — the neutral real rate — is estimated to be much lower. Lucas: And that's where the trouble starts. The Taylor Rule depends heavily on where you think the neutral real rate is. If r-star is one percent instead of two, the whole equation shifts down. Luna: Let's walk through a concrete example for mid-2026. Say core PCE inflation is running around three percent, and the output gap is about negative one percent — economy slightly below potential. Lucas: Using the original Taylor Rule with a neutral real rate of two percent, you get: one point five times three percent inflation, minus zero point five times one percent output gap, plus two. That's four point five plus zero point five plus two — a funds rate target of seven percent. Luna: But the actual funds rate today is probably closer to five and a half. So the rule says the Fed is too loose. Lucas: Unless you use a lower r-star. If the neutral real rate is one percent, the target drops to six percent. And if you think the output gap is actually zero, you get five point five percent — right where we are. Luna: So the rule is only as good as your inputs. And those inputs are highly uncertain. Lucas: That's the critique in a nutshell. But the rule still serves as a benchmark. When the Fed deviates from it, they have to explain why. Luna: There's also the question of the zero lower bound. During the financial crisis, the rule suggested negative rates, but the Fed couldn't go below zero. Lucas: Right. So they used quantitative easing instead. Some economists proposed a modified Taylor Rule that incorporates a shadow rate. But that gets complicated. Luna: And what about the global financial crisis period? In 2008, the Taylor Rule would have called for rates around negative five percent. The Fed never went there. Lucas: That's one reason the rule lost some of its official status. After 2008, central banks started saying they use the rule as 'one of many inputs' rather than a mechanical guide. Luna: But it's still widely taught and referenced in FOMC debates. Janet Yellen used to talk about it. Jerome Powell mentions it occasionally. Lucas: One newer variation is the 'balanced approach' rule, which puts equal weight on inflation and output gaps. The original Taylor Rule put more weight on inflation. Luna: And there's a 'first-difference' rule that avoids estimating r-star altogether — you just look at changes in inflation and output. Lucas: Right, the Evans rule from 2011. That one says don't raise rates until inflation is above two point five percent and unemployment is below a threshold. That was a different framework entirely. Luna: So it's not one rule — it's a family of rules. And the Fed has experimented with several. Lucas: Exactly. And what's interesting is that the original Taylor Rule was never intended to be followed blindly. Taylor himself said it's a guideline for making systematic decisions, not a straitjacket. Luna: But critics say that without a rule, policy becomes too discretionary and unpredictable — which can hurt long-term investment. Lucas: There's actually a lot of research showing that rule-like behavior reduces volatility in the bond market. When the Fed is seen as following a predictable pattern, long-term rates don't jump around as much. Luna: So even if the rule isn't perfect, having a rule-like framework is valuable. It's about communication and commitment. Lucas: Right. And that's why you'll see Fed staff at every FOMC meeting compute a range of simple rules and present them in the Tealbook. They're not binding, but they inform the conversation. Luna: Let's bring it back to the current moment. As of July 2026, the Fed has been holding rates steady for several meetings. Does the Taylor Rule say they should cut, hold, or hike? Lucas: That depends entirely on your estimate of r-star and the output gap. Most Fed participants seem to think the neutral real rate is around one percent or slightly lower. If you plug that in, the rule suggests the current rate of five point five percent is roughly appropriate. Luna: But if inflation stays sticky at three percent, and the output gap closes, the rule would start to say 'hike' again. Lucas: Exactly. And that's the tension we see in the dot plot — some members see a need for further tightening, others don't. The Taylor Rule gives a language for that disagreement. Luna: One more thing — the Taylor Rule doesn't incorporate financial stability concerns directly. That's a big gap. Lucas: That's a very good point. After the 2008 crisis, many economists argued that central banks should 'lean against the wind' of asset bubbles. But the Taylor Rule as originally formulated doesn't have a term for that. Luna: There have been attempts to add a financial conditions index or a credit gap. But it's not standard. Lucas: And that's probably why macroprudential tools — like loan to value limits and capital requirements — have become more important. They handle what the Taylor Rule misses. Luna: So the Taylor Rule is still central to how we think about monetary policy, but it's not the end of the story. Lucas: No, it's the beginning. It forces you to be explicit about your assumptions. And that discipline is valuable, whether you're a central banker or just an interested observer.