Adding Employment Growth to Taylor Rule Improves Its Ability to Predict Fed Policy Changes, Say Cleveland Fed Researchers

In normal times, the Federal Reserve conducts monetary policy by targeting the federal funds rate, the interest rate at which banks borrow funds from each other overnight. Some market watchers use a rule of thumb called the “Taylor rule” to help predict changes by the Fed in the funds rate target.  According to Federal Reserve Bank of Cleveland researchers Chuck Carlstrom and Saeed Zaman, adding employment growth to a standard Taylor rule can improve its effectiveness.

The Taylor rule says that changes in the federal funds rate will depend on the deviation of actual inflation from the Fed’s goal and on the gap between the economy’s current performance and its full potential. The gap can be measured in different ways, and other variables are often added to the rule to improve its performance.

Carlstrom and Zaman say a standard Taylor rule, which expresses the federal funds rate as a function of inflation, the unemployment gap, and the past Federal funds rate, tracks the funds rate well over time. But they find that the rule is even more effective when employment growth is added.

The researchers say adding current indicators like employment growth or GDP growth to the rule substantially improves the overall fit, especially during recessions, because they capture the changing pace of real economic activity. The authors say their version of the Taylor rule with employment growth added correctly predicts Fed policy actions 67 percent of the time, a substantial improvement over the version with just the unemployment gap, which predicts correctly only 49 percent of the time.

Read Using an Improved Taylor Rule to Predict When Policy Changes Will Occur

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