Latest / Monetary Policy Explained with Fexingo: Central Banks, Money Supply, and Interest Rates / How Central Banks Use the Taylor Rule to Set Interest Rates
Transcript
- Lucas: If you've ever wondered how central bankers actually decide where to set interest rates — not the philosophy, but the math — you've probably heard of the Taylor Rule. It's been around since 1993, and it's one of the most referenced, debated, and quietly ignored formulas in economics. Luna: I've seen it in Fed speeches and research papers, but I've always wondered: do they actually use it in real-time policy meetings, or is it just a rhetorical device? Lucas: That's exactly the right question. The rule was created by Stanford economist John Taylor, and it says: the appropriate federal funds rate should equal the neutral rate plus one point five times the inflation gap — that's actual inflation minus target — plus half the output gap. So if inflation is one percent above target and the output gap is negative, the rule might recommend holding rates steady. Luna: Right, so it's a simple linear equation, but the inputs are anything but simple. The neutral rate — that's r-star — is unobservable, and the output gap depends on potential GDP, which is also a guess. Lucas: Exactly. And that's where the rubber meets the road. Taylor originally assumed a neutral rate of around two percent, but since the 2008 financial crisis, many estimates put it closer to zero or even negative in real terms. So if you plug in different neutral rates, the rule gives you wildly different prescriptions. Luna: So it's not a precise tool — it's more like a framework for thinking about how policy should respond to deviations. But I recall that during the Volcker era, the rule would have recommended astronomically high rates. Lucas: Right. If you apply the original Taylor Rule to the early 1980s, you'd get a federal funds rate above twenty percent. Volcker actually went higher than that, but the point is the rule captures the logic: when inflation is way above target, rates need to rise decisively. In the 2000s, however, some argued that the Fed kept rates too low for too long because they were using a different version of the rule. Luna: That became a big debate after the dot-com bust and the housing bubble. Critics like John Taylor himself argued that if the Fed had followed his rule in the early 2000s, the housing bubble might have been smaller. Lucas: Exactly. In a 2007 paper, Taylor claimed that from 2002 to 2005, the actual federal funds rate was about one percent below what the rule recommended. That deviation, he argued, fueled the housing boom. But other economists counter that the rule's prescription depends on which inflation measure you use — core PCE vs. headline CPI — and how you measure the output gap. Luna: So even the rule's own creator says the Fed strayed from it, but the Fed would argue their discretion was justified because the economy was facing deflation risks and a jobless recovery. Lucas: Precisely. And that tension between rule-based and discretionary policy is one of the oldest debates in central banking. The Taylor Rule gives you a benchmark, but it's not a straitjacket. Most central banks, including the Federal Reserve, use it as one input among many. In fact, Fed staff often produce a 'Taylor Rule' estimate in the Tealbook — the document prepared before each FOMC meeting — but the committee rarely follows it mechanically. Luna: So when you read a transcript from a 2019 meeting, you might hear a governor say 'the Taylor Rule suggests we should cut rates, but I'm concerned about financial stability.' That's the discretion part. Lucas: Exactly. And during the pandemic, the rule would have pointed to negative rates, which the Fed was unwilling to do. So they used forward guidance and quantitative easing instead. The rule is a guide, not a command. Luna: It also doesn't account for unconventional tools. So when rates are at the effective lower bound, the rule breaks down. That's why people like former Fed Chair Ben Bernanke proposed modified versions that incorporate a shadow rate. Lucas: Right, the 'Bernanke rule' or the 'balanced-approach rule' include a term for the lagged federal funds rate, which smooths the path. There are actually several variants that the Fed publishes in its Monetary Policy Report. As of the last report, there were three main alternatives: the original Taylor Rule, the balanced-approach rule, and the first-difference rule, which only looks at changes in inflation and output. Luna: And each gives different advice. So which one do they actually use? Or do they average them? Lucas: They don't use any single one. Chair Powell has said they're 'useful benchmarks' but that policy will be made based on a broad assessment of the economy. In practice, the FOMC has been more data-dependent than rule-bound. But the Taylor Rule does serve a rhetorical purpose: it anchors expectations and provides a transparent framework that the public and markets can monitor. Luna: And that transparency is valuable. If markets can see that policy is broadly consistent with a rule, they can anticipate moves. But if the Fed suddenly deviates without explanation, it can cause confusion. Lucas: Right. And that's where the criticism from the 'rules-based' camp comes in. Some economists argue that central banks should commit to a rule to reduce uncertainty. But others say no rule can capture every contingency, and discretion is necessary. The truth is, every central bank uses a mix. Luna: So where does the Taylor Rule sit today? With inflation still above target in many economies, what would the rule recommend now? Lucas: Well, as of mid-2026, most Taylor Rule variants suggest that the federal funds rate should be in the range of four to five and a half percent. The actual rate is close to that, maybe a bit lower. The output gap is probably closed or slightly positive, and inflation has come down but is still above two percent. So the rule says 'hold here or tighten a little more.' But the Fed is also watching lags in policy effects and the labor market. Luna: And that's the key: the rule doesn't tell you how fast to move. It gives you a destination, but not the speed limit. That's where judgment comes in. Lucas: Exactly. And honestly, if today's episode clarified something for you — if it was worth the price of a coffee — you can find us at buy me a coffee dot com slash fexingo. Luna: That kind of support is what keeps this show ad-free and independent, and we really appreciate it. Lucas: So where does that leave us? The Taylor Rule is a guide, not a GPS. It's a way to discipline your thinking, not a substitute for it. The best central bankers use rules like this to check their biases, but they also know when to override them. Luna: And as the economy evolves, so will the rules. We're already seeing new research on how to incorporate financial stability, climate risks, and global spillovers into these frameworks. Lucas: That's a topic for another episode. For now, the takeaway is: next time you hear a Fed official mention the Taylor Rule, you'll know it's a benchmark, not a binding constraint. Luna: And you might even be able to compute your own estimate, if you're feeling ambitious. Lucas: Exactly. I'm Lucas. Luna: And I'm Luna. Lucas: Thanks for listening to Monetary Policy Explained with Fexingo.