Taylor Rule
Taylor Rule

A Simple Equation with Powerful Possibilities

The Taylor Rule (formulated in 1993) is the brainchild of an economist from Stanford University, John Taylor. This formula is geared towards the US Federal Reserve Bank, and other central banks around the world to determine the optimal short-term interest rates. Decisions are based upon 3 critical elements, including the unemployment rate, economic growth, and inflation. The Taylor Rule references the ‘real’ short-term interest-rate, not the ‘nominal’ short-term interest rate.

The distinction is important, since it takes inflationary effects into account. According to Taylor, interest-rate determinations are dependent upon the difference between the targeted inflation rate (set by the central bank) and the actual inflation rate.

It is equally important to assess the optimal interest rate required for maintaining full employment, and how much more economic activity is needed for full employment to be reached. Such is Taylor's pedigree, that he has served with distinction as a member of the President's Council of Economic Advisers, and Undersecretary of the Treasury for International Affairs, among others.

The formula used to denote the Taylor Rule is as follows: r = p + .5y + .5(p – 2) + 2

  • r represents the Federal Funds Rate (FFR)
  • p represents the inflation rate
  • y represents the deviation from the central banks targeted rate and real GDP

From a monetary policy perspective alone, the Taylor Rule offers a groundbreaking framework upon which real short-term interest rates can be determined. As a monetary policy resource, this mathematical formula can impact the way that central banks determine interest rates, without being influenced by anything other than pure economics.

Of course, naysayers claim that the Taylor Rule can be detrimental to monetary policy decision-making, given its rather limited perspective on factors that control real short-term interest rates. This rather simple formula for determining interest-rate policy has hard and fast rules for setting the interest rate.

The Taylor Rule in Action: Simple and Effective?

For example, let’s assume that the Fed has an inflation rate target of 2%. Given the formula, the correct interest rate would be 4%. As the inflation rate increases by 1%, the interest rate should be cut by 1.5%. Conversely, if the inflation rate decreases by 1%, the interest rate should be decreased to 3%. Thus, there is a clear correlation between inflation rates and interest rates, albeit disproportionately.

Assuming an inflation rate of 6% and the central bank’s targeted rate of 2%, the formula tells us what the Federal Funds Rate should be:

  • r = 6 + .5(4) + .5(6 – 2) + 2.
  • r = 12%

The complexity of working with the Taylor Rule lies in the details. Many macroeconomic variables are absent from the equation, leading many to believe it is an inadequate representation of real-world conditions.

For example, a country's level of indebtedness can also impact interest rates. These financial imbalances can have an outsized impact on the demand for safe-haven assets like gold. In and of itself, an inflation rate is difficult to measure.

There are different types of inflation differentials such as PPI, GDP deflators, CPI, core CPI and many others. Picking the right inflation measure is critical to the determination of real short-term interest rates.

Truth be told, there are effectively multiple Taylor Rules at play all of the time. There is no one-size-fits-all approach to implementing the Taylor Rule since there are nebulous parameters to work with. As a registered trader, you may be tempted to implement the Taylor Rule when trading gold online. It is worth pointing out that you will be required to determine portfolio diversification to get the right AUD balance, establishing the correct weighting requirements, and rebalancing where necessary.

Once you're confident about these investment-related decisions, you can start trading for real money at AvaTrade. Be advised that the Taylor Rule is not necessarily a ‘Debbie Downer’ for gold prices, given that there are so many different versions of this formula that can be applied.

The Taylor Rule is predicated on many assumptions. While these can certainly be modified to meet requirements, the gist of it assumes a steady real interest rate, and a target inflation rate. The purpose of the Taylor Rule is simply to determine the central bank rate, given a list of variables. This rule has been commended in terms of its ability to clearly explain US macroeconomic policy for the past 60 years.

In the 1960s, economic growth was strong, and inflation was low. During the early 1980s for example, the Federal Funds Rate was lower than what the Taylor Rule prescribed, and during the latter half of the 1980s, the Federal Funds Rate was higher.

It is noteworthy that the US economy entered a period of virtually zero inflation after the Global Financial Crisis. According to Taylor, the Federal Funds Rate should have been -7%, but things worked out just fine. It is prescriptive in nature, but not mandatory. Many experts agree that the Taylor Rule is but one of many monetary policy resources that should be considered, within the broader framework of global output levels and worldwide inflation to get the right balance for monetary policy.

Central Bank Policy with the Taylor Rule

Assuming the RBA (Reserve Bank of Australia) wants to implement the Taylor Rule in its monetary policy-making decisions, there are a few easy-to-follow prescriptions:

  • Monetary policy will be tightened by raising the interest rate one half of a percentage point for every one percentage point that inflation increases relative to the targeted rate.
  • Monetary policy will be tightened by one half of a percentage point for every percentage point that GDP increases relative to its potential.

The eponymous developer of the Taylor Rule, John Taylor, indicated early on that his mathematical formula did not consider all of the factors that actually influence central bank policy-making decisions. Given the complexity of central bank decision-making, a myriad of factors needs to be considered when setting interest rates.

In fact, Dr. Taylor advocates for monetary policy to align with the Taylor Rule, and other formulae like it in order to determine interest rates. An evaluation of the actual Federal Funds Rate from 1994 through 1999 indicates that it was higher than the prescribed rate using the GDP deflator and lower than the Taylor Rule GDP deflator between 2003 and 2007. In recent years, the Taylor Rule GDP deflator has been higher than the actual Federal Funds Rate by quite a margin.

Now that you understand the inner- mechanics of the Taylor Rule, and its prescriptive mechanics, you can confidently register at AvaTrade and see how far central bank policy is from the rule and how that will impact trading and investment activity on safe-haven assets, shares, commodities, indices, and currencies.