Using Taylor rule as a policy guide? Cleveland Fed researchers urge caution

The Taylor rule, often thought to be a useful guide to monetary policy, has been garnering more attention lately amid speculation about the potential timing of an increase in the Federal Reserve’s target interest rate, the federal funds rate. The Taylor rule expresses the fed funds rate as a function of how far inflation is from its long-run target and how far output, or alternatively, employment, is from its potential. Since both potential concepts are hard to measure with any precision, Federal Reserve Bank of Cleveland researchers Charles Carlstrom and Timothy Stehulak caution that care should be taken when using a Taylor-type rule to make Fed policy predictions or recommendations.  

The researchers point out that estimates of potential GDP and the natural rate of unemployment are very fluid. For example, they say that the Congressional Budget Office’s 2007 estimate of what potential output would be in 2015 differs from its current estimate by roughly a trillion dollars, which translates into nearly a 7 percentage point difference in the output gap. Also in 2007, the CBO estimated that the natural rate of unemployment was, and would remain, at 5.0 percent. But today, the estimate is 5.4 percent. 

Carlstrom and Stehulak also note that using different versions of the Taylor rule with these different estimates produces much different policy prescriptions. For example, if the Fed would have followed an unemployment Taylor rule since 2006, given today's estimate of the natural rate, the funds rate in 2015:Q1 would be 1.85 percent. But with the CBO's 2007 estimates it would be 0.59 percent. With today's gap estimates, the output Taylor rule today would prescribe a funds rate of 0.64 percent. But with the 2007 estimates, the Taylor rule would give an unrealistic prescription of -5 percent.

Because of the relatively large share of employment that is part-time, some think that today the output gap may be a better measure of slack in the economy than the unemployment gap. While these are important issues for the stance of policy, Carlstrom and Stehulak say that we cannot be sure that today's gap estimate will not change as more data unfolds, and that, unfortunately, there is no clear right or wrong answer. However, they say it does suggest that perhaps relatively more attention should be paid to inflation in setting policy than to slack estimates.

Read Mutable Economic Laws and Calculating Unemployment and Output Gaps – An Application to Taylor Rules

Interested in some insights as to why core inflation has been persistently low? Read The Gap between Services Inflation and Goods Inflation.

Federal Reserve Bank of Cleveland

The Federal Reserve Bank of Cleveland is one of 12 regional Reserve Banks that along with the Board of Governors in Washington DC comprise the Federal Reserve System. Part of the US central bank, the Cleveland Fed participates in the formulation of our nation’s monetary policy, supervises banking organizations, provides payment and other services to financial institutions and to the US Treasury, and performs many activities that support Federal Reserve operations System-wide. In addition, the Bank supports the well-being of communities across the Fourth Federal Reserve District through a wide array of research, outreach, and educational activities.

The Cleveland Fed, with branches in Cincinnati and Pittsburgh, serves an area that comprises Ohio, western Pennsylvania, eastern Kentucky, and the northern panhandle of West Virginia.

Media contact

Doug Campbell, doug.campbell@clev.frb.org, 513.455.4479