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The Fed “Lift Off” and the Taylor Rule

By: Tom Goodwin, PhD, Senior Research Director

The long, long drum roll has stopped and the Federal Reserve has finally begun raising its key interest rate for the first time in nearly a decade. On December 16 it announced a 0.25% increase to a range of 0.25-0.50%. Market participants are now trying to get a sense of how far and how fast the rate rise might go.

In an effort to shed light on the rate setting process, Professor John Taylor of Stanford University developed a simplified rate calculation that tracks the history of rate setting remarkably well, suggesting there is a rules-based component to policy deliberations.[1] But times such as the present--when the Taylor Prescribed Rate doesn't track the actual Fed Funds rate--can be even more illuminating.

The “Taylor Rule,” as it has come to be known, is a simple mathematical formula that calculates a rule-based prescribed policy Fed Funds rate based on the Fed’s twin policy goals of inflation and unemployment:

The approach is straightforward: a neutral policy rate of 4.0% (2.0% real return to capital + 2.0% inflation) is the rate prescribed when inflation and unemployment goals are reached. Deviations from this rate are driven by inflation and unemployment gaps. For every percentage point that “core” inflation (all items except food and energy) is above (below) the inflation target of 2.0%, the prescribed rate is increased (decreased) by 1.5%. For every percentage point actual unemployment is above (below) target unemployment of 5.0%, the prescribed rate is decreased (increased) by 1.0%.

These parameters aren't arbitrary--they're the assumptions most often used by economists.[2] And the chart below illustrates that historically this calculation hasn't been too far off the mark, at least from a directional standpoint.

As pictured, the Taylor Prescribed Rate roughly describes the actual Fed Funds rate prior to 2009, with some departures. Deviations are most noteworthy at the beginning of the last three recessions, when the Fed acted more quickly to lower the rate than the Taylor Rule would prescribe. And in the case of the 1990 and 2001 recessions, the Fed lowered the rate further than prescribed by the Taylor Rule to stimulate a recovery. But aside from these differences, up until 2009 the Taylor Rule appears to be a useful guide for tracking the Fed funds rate.

The period thereafter tells a different story. The sharp divergence between the Taylor Rule and the Fed Funds rate began in 2009, when the unemployment rate peaked at 10%. And while this led to negative rates prescribed by the Taylor Rule, the Fed could only lower the Fed Funds rate to zero–as low as conventional monetary policy would allow. This of course gave rise to the array of unconventional policies known as “quantitative easing.”

As economic indicators have since improved, the Taylor Prescribed Rate has risen commensurately, reaching a level that is close to the “policy neutral” rate of 4.0%. Yet the Fed Funds Rate has flat-lined, hovering steadfastly near zero.

The resulting divergence between the Taylor Prescribed Rate and the actual Fed Funds rate suggests there has been a growing pressure to raise rates. The current large gap between the Prescribed Rate and the current Fed Funds rate provides some context for market observers when assessing the latest “lift off” and future likely moves by the Fed.

[1] Taylor, J. (1993), “Discretion Versus Policy Rules in Practice,” Carnegie-Rochester Conference Series on Public Policy, 39, 195-214.

[2] Rosenberg, M. (2010), “Fed Funds Rate Outlook – A Taylor Rule Perspective,” Bloomberg Financial Conditions Watch, 27 January.


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