Now and again, when you’re listening to analysts talking about US Federal Reserve interest-rate policy, you’re likely to hear them discuss whether or not, or to what extent, the Taylor Rule should be applied. Stanford economist John Taylor formulated his rule to instruct central banks on how to adjust interest rates, based on current rates of inflation and the state of the economy.
The rule is a mathematical formula that, generally speaking, tells policymakers to respond to high inflation or excessive GDP by hiking interest rates, and to reduce rates when inflation drops too much or GDP isn’t growing fast enough.
Taylor’s Rule is not the only interest-rate-setting rule out there (other well-known rules include, for instance, the Balanced-Approach rule or the First-Difference Rule), nor is its power to set rates correctly under all circumstances universally acknowledged. The Fed actually say that the benefit they seek in consulting any given rule is, not so much to get a single, clear answer on how rates should be set, but rather to derive “a starting point for thinking about the implications of incoming information for the level of the federal funds rate”. The federal funds rate is the tool most often manipulated by the Fed to institute their monetary policy. This rate directly impacts banks when they loan from one another, and also influences US-dollar forex pairs.
When Taylor originally proposed his rule back in 1993, he showed that it described Fed policy in recent years quite accurately. He also only implied that it should be used as a general reference for policymakers, and didn’t say it should be adhered to at all times and under all circumstances. A few years later, however, Taylor seemed to argue that his rule should prescribe monetary policy at almost all times and criticized the Fed for not applying it between 2003-2005, when the groundwork for the 2008 recession was laid.
Your forex trading with US-dollar pairs is impacted every time the Fed raises or lowers interest rates, so let’s learn a bit more about how the Taylor Rule works, and also about it shortcomings, in order to build our understanding of central bank policy.
About the Taylor Rule
Taylor’s motivation for introducing the Rule in the first place was a perceived shortcoming in pre-existing models used to fix Fed policy. Specifically, these models seemed deficient in looking only backwards and in ignoring the longer-term economic picture. Taylor felt he had devised a more powerful, forward-looking model to assist in shaping Fed policy.
Taylor’s formula gives inflation the highest status of all in determining interest rates. This itself is one of its weaknesses because the Fed has, not one, but two main objectives: stabilizing prices and keeping employment high. For another thing, the Taylor Rule ignores the other tools at the Fed’s disposal when it wants to influence the economy, for instance quantitative easing, which refers to big asset purchases made by the central bank. In terms of the Rule’s potency, it has proved fairly effective during healthy economic times, but not so when crisis looms. Despite all this, policymakers have consistently consulted the Rule as a guide since its emergence in the early nineties.
The 2008 Financial Crisis
Taylor said that, if central banks had followed his rule in the early 2000’s, interest rates would have been held higher, money would have been less easily available, and fewer people would have elected to buy homes. As a result, the housing bubble of 2008 would not have ended up so large and the financial crisis would have been less severe.
This view has been contested by, for example, former head of the FOMC (Federal Open Market Committee) Ben Bernanke, who wrote that Fed policy in the years 2003-5 “can’t explain the size, timing, or global nature of the housing bubble”. Bernanke went further and pointed out that “the simplicity of the Taylor Rule disguises the complexity of the underlying judgements that FOMC members must continually make”.
The Federal Reserve are well aware that the complexity of their job demands much more than a single mathematical formula. An example they mention of that complexity is the fact that demographic changes or technological innovations sometimes create the need for resources to be redispersed from one sector to another. More generally, analysts have noted that the volatility of the real world makes a single-formula policy virtually impossible.
Wrapping Up
A recent case illustrating the challenges to the Rule was the arrival of the Covid-19 pandemic in 2020. The Fed were understandably concerned about a slowdown in economic growth and so kept interest rates low, while the Taylor Rule looked only at the need to tame inflation, and pointed to higher rates. In fact, Taylor himself has admitted that “monetary policy will need to be adjusted to deal with special factors”.
If you trade on iFOREX’s one-of-a-kind platform, you’ll be able to check on the live rates of your pair by glancing down at your smartphone. At the same time, learning about the rules used to guide Fed policy helps you view the information in the right perspective, which is why iFOREX offers a generous store of educational materials too.
