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The Taylor Rule

Adam M. Grossman

IF YOU’VE TRIED TO buy a car or a home recently—or have even just been to the grocery store—I’m sure you’re aware how much prices have jumped over the past year. John Taylor certainly has an opinion on the topic.

Taylor is an economics professor at Stanford University. While not a household name, he’s a leader in economic circles. Before Jerome Powell was appointed Federal Reserve chair in 2018, Taylor was a candidate for that spot.

According to one analysis, Taylor’s name is the one most frequently referenced in Fed policymakers’ meetings. That’s because he’s the creator of what’s known as the Taylor rule. Despite being a frequent critic of Fed policy, he and his rule are well respected, so it’s worth taking a closer look.

The purpose of Taylor’s rule is to provide a framework for interest rates—the federal funds rate, specifically. That’s the interest rate the Fed controls directly. It’s often referred to as the “benchmark rate” and is important because all other interest rates—from mortgages and car loans to savings account rates and bond yields—are set in relation to it. When people talk about the Fed raising or lowering interest rates, this is the rate they’re referring to. It’s enormously important.

For simplicity, I’ll describe the Taylor rule in words. If you want to see the formula itself, you can find it on the Federal Reserve Bank of Atlanta’s website. In general terms, this is how it works: It assumes, as a starting point, that inflation and gross domestic product growth should both be about 2% in normal times. Then it dictates that the federal funds rate should be adjusted upward if the economy is running above those targets or downward if below. These inputs are referred to as the “inflation gap” and the “output gap.”

The formula’s underlying logic is based on the Fed’s official mandate: to maintain “maximum employment, stable prices, and moderate long-term interest rates.”

This, in general, is what the Fed always does. It raises rates when the economy is running too hot, and it lowers them when things are lagging. But Taylor’s framework is different because it offers a formulaic approach to setting rates. That’s in contrast to the Fed’s current process, which is committee-driven.

In Taylor’s view, a rule-driven approach would be preferable for two reasons. First, it would keep Fed policymakers disciplined by removing the subjective element from their decision making. Second, a formulaic approach would offer the general public a better idea of where rates are headed. That’s important because, in policymaking, a key goal is to avoid surprises that might cause panic.

In fairness, the Fed does try to telegraph its thinking and its intentions. In press releases and in the chair’s Congressional testimony, the Fed provides “forward guidance” to communicate its expectations for the economy and for interest rates. Forward guidance refers to the carefully scripted phrases used by Fed officials, such as “a balanced approach” and “considerable time.” The Fed’s forward guidance is so carefully watched that news outlets literally parse every word. Here’s an example.

The Fed also issues guidance in quantitative form. At each meeting, the Fed’s rate-setting committee polls its members, asking where they see the benchmark rate headed. It then publishes the results in a document called the Summary of Economic Projections.

Taken together, these communications serve a key purpose: They allow the market to adjust gradually to future policy changes. An example is playing out in real-time right now. So far this year, the Fed has raised its rate by a total of three-quarters of a percentage point. The rate on many Treasury bonds, however, has increased disproportionately more. This might seem inconsistent—until you look at the forward guidance.

In its press release, the committee previewed “ongoing increases.” And its most recent Summary of Economic Projections specifically pointed to an increase of another one percentage point in the back half of this year. In short, the Fed does a reasonable job communicating its thinking to help the market adjust gradually.

For that reason, Taylor is less concerned with the Fed’s communications. He is much more concerned with its underlying decision-making process. On too many occasions, he argues, the Fed has left rates at unnecessarily low levels for years at a time. This has had the effect of inflating more than one asset bubble—in housing and in technology stocks, among others.

Most recently, Taylor says, the Fed was too complacent about rising inflation, repeatedly calling it “transitory.” If it had been following a more rules-based approach, he argues, rates would have risen much earlier. Instead, the Fed had to play catch-up this year when it finally acknowledged that the heightened inflation was not transitory and was, in fact, getting worse. As Taylor put it recently, “They are strikingly behind.”

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Fed officials, though, are quick to push back against Taylor’s formulaic prescription. Recently, retired Federal Reserve Bank of Boston President Eric Rosengren cited 2007 as an example. At that time, the Taylor rule wouldn’t have registered a problem, but Fed officials were able to detect other signs pointing to a crisis, allowing them to respond more quickly.

Former Fed Chair Ben Bernanke has made similar arguments. In a 2015 paper, written after his term ended, Bernanke argued that economic policymaking is far too complex to be delegated to a simple formula.

Among the complications: While the inflation gap is straightforward to measure, Bernanke points out that there are several ways to measure the output gap, each of which would yield a different number. In short, Bernanke says, it wouldn’t make sense to rely rigidly on a formula when at least one of its inputs is subjective.

There are other issues with the Taylor rule. In addition to the challenge described above, there’s the question of how to weight the two factors in the formula. In Taylor’s original formula, he weighted the inflation and output gaps equally. But arguments could be made for weighting them differently. After all, unemployment and inflation are both scourges. It’s debatable which is worse.

Who’s right in this debate? To be sure, Taylor makes a valid argument. Many agree that the Fed, going back at least to the 1990s, has been too permissive. Rates were held near zero well after the economy had regained its footing after the 2000 downturn. And it held rates near zero for years after the 2008 financial crisis—waiting until the very end of 2015 to increase them.

Though Bernanke strenuously disagrees with Taylor’s criticism, he also validates it by taking the time to write a rebuttal. At the same time, Bernanke and fellow policymakers have a point when they argue that a formula—any formula—would be necessarily imperfect because the inputs are subjective. Indeed, on the Fed’s website, it describes several alternative formulas, each of which has its own reasonable basis. Also, as Eric Rosengren noted, formulas can’t see around corners.

As an individual investor, what should you conclude from this debate? In my view, the Fed’s Summary of Economic Projections says it all. It’s a dry document, but if you read between the lines, it tells us a lot.

For starters, it includes not just the average opinion of committee members but also the range of views. In addition, each update includes the committee’s prior view, making it easy to see how its forecasts have changed over time.

The upshot: Just as the stock market is unpredictable, so too is government policy. As this document reveals, even policymakers themselves—probably the most well-informed economic observers anywhere—regularly disagree with one another and regularly change their views.

That’s why an investor’s best bet, in my view, is to always maintain a balanced portfolio. At any given time, some investment will always feel out of step with current trends, and yet that itself may be the best litmus test of a well-diversified portfolio. If there’s always at least something that doesn’t feel quite right, then your portfolio might indeed be just right.

Adam M. Grossman is the founder of Mayport, a fixed-fee wealth management firm. Sign up for Adam’s Daily Ideas email, follow him on Twitter @AdamMGrossman and check out his earlier articles.

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R H
R H
1 month ago

Often wrong but never in doubt, I think of economists much like meteorologists.

Will
Will
1 month ago

Loved this neutral look at the machinations and the explanations. I wonder why 2% is the magic number. I mean, is 2% the correct goal, or 0.2% or some other number better? Does an improved quality of life necessarily inflationary?

parkslope
parkslope
1 month ago

Excellent article. Taylor’s rule is in line with a large body of decision-making research.
Dawes, R. M., Faust, D., & Meehl, P. E. (1989) Clinical versus actuarial judgment. Science, 243:1668-1674
Professionals are frequently consulted to diagnose and predict human behavior; optimal treatment and planning often hinge on the consultant’s judgmental accuracy. The consultant may rely on one of two contrasting approaches to decision-making—the clinical and actuarial methods. Research comparing these two approaches shows the actuarial method to be superior. Factors underlying the greater accuracy of actuarial methods, sources of resistance to the scientific findings, and the benefits of increased reliance on actuarial approaches are discussed.
https://meehl.umn.edu/sites/meehl.umn.edu/files/files/138cstixdawesfaustmeehl.pdf

Nate Allen
Nate Allen
1 month ago
Reply to  parkslope

Also, the fact that checklists are used to such great effect in fields such as aviation, surgery, etc. to reduce human error. Anything we can take out of the hands of human decision making would likely be better in most circumstances. Obviously there will always be outliers, as pointed out above.

wtfwjtd
wtfwjtd
1 month ago

Thanks Adam. Your write-up brings into sharp focus, the fact that successful investors are focused more on long-term outcomes, while politicians are (myopically) focused on short-term outcomes. The Federal Reserve is supposed to intermediate these two sometimes diametrically opposed extremes, attempting to optimize short-term results, without damaging long-term prospects. Obviously, they don’t always succeed, and investors are left trying to position themselves ideally between the two. At times, it’s not easy, and thanks for the reminder that, even though at times it’s not very exciting, portfolio diversity is probably the best tool we’ve got to navigate this successfully.

Jack Hannam
Jack Hannam
1 month ago
Reply to  wtfwjtd

Adam, as usual, did an excellent job summarizing and explaining a complex topic. And I agree with your comments on short term versus long term outcomes. It seems ironic to me that many CEOs’ and investment managers’ performance evaluations may be based on short term outcomes, while as a long term investor myself, it is the long term outcome which is most important.

Bruce Trimble
Bruce Trimble
1 month ago
Reply to  Jack Hannam

Not really ironic. CEOs and investment managers’ get huge bonuses for short term results. And for CEOs? If they destroy a company they walk off with a multi-million golden parchute.

Patricia shmidheiser
Patricia shmidheiser
1 month ago

Thank you, very informative article. It makes sense to automate the gears and flyweights of the economic “governor” as much as possible.

R Quinn
R Quinn
1 month ago

I’m not one for details, but I really enjoyed this piece and learned from it. Seems like it comes down to not having all your eggs in one basket.

Nate Allen
Nate Allen
1 month ago

There definitely seems to be a “pressure” to hold rates as low as possible for as long as possible in “normal” times, which seemingly creates bubbles. I’m not smart enough to know if a formula would work better, but generally not keeping rates at the rock bottom for as long as possible seems like it would produce better outcomes overall.

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