How Useful Are Taylor Rules For Monetary Policy?
How Useful Are Taylor Rulesfor Monetary Policy?By Sharon Kozickiver the past several years, Taylor ruleshave attracted increased attention ofanalysts, policymakers, and the financialpress. Taylor rules recommend a setting for thelevel of the federal funds rate based on the stateof the economy. For instance, they may recommend raising the federal funds rate when inflation is above target or lowering the federal fundsrate when a recession appears to be more of athreat. Taylor rules have become more appealingrecently with the apparent breakdown in therelationship between money growth and inflation (Blinder). But, while Taylor rules haveattracted considerable interest, the usefulness ofrule recommendations to policymakers has notbeen well established.OTo be useful to policymakers, rule recommendations should be robust to minor variations inthe rule specification. While most analysts andpolicymakers agree on the fundamental featuresof a monetary policy rule, consensus has notbeen reached on the details of the specification.The Taylor rule is a specific rule that incorporates several assumptions. Rule recommendations should be robust if these assumptions areSharon Kozicki is an assistant vice president and economistat the Federal Reserve Bank of Kansas City. CharmaineBuskas and Barak Hoffman, research associates at thebank, helped prepare the article. This article is on thebank’s Website at www.kc.frb.org.replaced by reasonable alternatives. For example, rule recommendations would not be robustif different measures of price inflation yield awide range of rule recommendations. If recommendations differ considerably depending onwhether price inflation is measured using thecore consumer price index or the chain priceindex for GDP, then the rule may not be veryuseful.Rule recommendations should also be reliable.A reliable rule might be expected to replicatefederal funds rate settings over a period whenpolicymakers thought policy actions were successful. If past policy decisions are regardedfavorably, then policymakers may want to basecurrent decisions on a similar strategy. To theextent rule recommendations replicate past favorable policy settings, policymakers may regardthe rule as reliable. But, even a rule that canreplicate favorable policy actions may not beregarded as reliable if past policy decisions wereinfluenced by economic events beyond the scopeof the rule.This article examines whether recommendationsfrom Taylor rules are useful to policymakers asthey decide how to adjust the federal funds rate.The article suggests that the usefulness of Taylorrule recommendations to policymakers facedwith real-time policy decisions is limited. Rule
6recommendations are not robust to reasonableminor variations in assumptions and their reliability is questionable.1 Taylor rules may be useful to policymakers in other ways. For example,because they incorporate the overall characteristics of sound monetary policy generally agreed onby analysts and policymakers, Taylor rules mayprovide a good starting point for discussions ofissues that concern policymakers. Monetary policy rules also play an important role in most forecasting models.The first section of the article describes the Taylor rule and discusses common generalizations ofthe Taylor rule. The second section examines therobustness of rule recommendations to small differences in rule specifications. The third sectionassesses the reliability of rule recommendations.I. WHAT ARE TAYLOR-TYPERULES?This article focuses on a class of policy rulesthat model the federal funds rate target as a function of the deviation of inflation from a target rateand the deviation of real GDP from potential realGDP (that is, its long-run sustainable trend).2 Therules assume that policymakers seek to stabilizeoutput and prices about paths that are thought tobe optimal and that by changing the federal fundsrate target they can influence output and prices(Cecchetti). Such rules are often called Taylorrules because they resemble a simple rule, knownas the Taylor rule, suggested by John Taylor in1993. This section reviews the Taylor rule anddiscusses a class of similar rules that incorporatethe same basic framework for policy. In theremainder of the article, this class of similar ruleswill be referred to as Taylor-type rules to distinguish them from the original Taylor rule.The Taylor ruleThe Taylor rule recommends a target for thelevel of the nominal federal funds rate that dependson four factors.3 The first factor is the currentFEDERAL RESERVE BANK OF KANSAS CITYinflation rate. The second factor is the equilibrium real interest rate. When added together,these two factors provide a benchmark recommendation for the nominal federal funds rate.The third factor is an inflation gap adjustmentfactor based on the gap between the inflationrate and a given target for inflation.4 This factorrecommends raising the federal funds rate abovethe benchmark if inflation is above the target forinflation and lowering the federal funds ratebelow the benchmark if inflation is below thetarget. The fourth factor is an output gap adjustment factor based on the gap between real GDPand potential real GDP. This factor recommendsraising the federal funds rate above the benchmark if the gap is positive (real GDP is abovepotential real GDP) and lowering the federalfunds rate below the benchmark if the gap isnegative (real GDP is below potential realGDP). These factors summarize several important aspects of policy.5The sum of the first and second factors provides a benchmark recommendation for the federal funds rate that would keep inflation at itscurrent rate, provided the economy is operatingat its potential. Because the benchmark recommendation rises one-for-one with the currentrate of inflation, the higher current inflation is,the higher the rule recommendation will be, allelse equal. This relationship between currentinflation and the benchmark recommendationfor the nominal federal funds rate keeps theimplied real interest rate constant.The use of the equilibrium real rate in the Taylorrule emphasizes that real rates play a central rolein formulating monetary policy. Although the nominal federal funds rate is identified as the instrument that policymakers adjust, the real interestrate is what affects real economic activity. In particular, the rules clarify that real interest rates willbe increased above equilibrium when inflation isabove target or output is above its potential.The third and fourth factors in the Taylor rule
ECONOMIC REVIEW l SECOND QUARTER 1999summarize two objectives of monetary policy—targeting a low and stable rate of inflation whilepromoting maximum sustainable growth. Theseadjustment factors can also be seen as incorporating both long-run and short-run goals. The inflation gap adjustment factor incorporates the centralbank’s long-run inflation goal. The output gapadjustment factor incorporates the view that inthe short-run policy should lean against cyclicalwinds. Weights in the adjustment factors embodya presumed attitude toward the short-run tradeoffbetween inflation and output.The output gap adjustment factor may representanother aspect of policy. Some analysts haveargued that the output gap adjustment factorbrings a forward-looking, or preemptive, motiveto policy recommendations. According to thisview, a positive output gap signals likely futureincreases in inflation. Consequently, funds raterecommendations that reflect an output gapadjustment may correspond to policy actionsdesigned to preempt an otherwise anticipatedincrease in inflation.Although the Taylor rule incorporates manyimportant aspects of policy, it also is based onseveral assumptions. Assumptions of some formare necessary to move from a framework for policyto a rule that provides quantitative recommendations.6 The specific rule discussed by Taylor takesthe following form:funds rate(t) GDP price inflation(t) 2.0 0.5 (GDP price inflation(t) – 2.0) 0.5 (output gap(t)).(1)In this expression, the benchmark recommendation is the sum of GDP price inflation and the2.0 percent equilibrium real rate. The third termon the right side of the expression is the inflationgap adjustment, which raises the funds rate targetby one-half of the gap between GDP price inflationand the 2.0 percent inflation target. The fourthterm on the right side of the expression is the output gap adjustment, which raises the funds rate7target by one-half of the output gap, where theoutput gap is defined as the percent deviation ofthe level of real GDP from the level of potentialreal GDP.7Assumptions are embedded in all componentsof the rule. Taylor-rule recommendations in agiven quarter are based on the output gap in thesame quarter and on inflation over the four quarters ending in the same quarter. In the Taylorrule, monetary policy targets GDP price inflation measured as the rate of inflation in the GDPdeflator over the previous four quarters. Theequilibrium real rate, represented by the secondterm on the right side of the expression, is assumedto equal 2.0 percent. The inflation gap adjustment incorporates a weight equal to one-half.The policy target for inflation is assumed toequal 2.0 percent. The output gap adjustmentincorporates a weight equal to one-half. And, theoutput gap is constructed using a series for potential real GDP that grows 2.2 percent per year.Taylor-type rulesTaylor presented his rule as a simple, representative specification that captured the general framework for policy discussed earlier. Because thereis a lack of consensus about the exact specification,evaluating alternative similar specifications isimportant when assessing the usefulness of rulerecommendations. The details of the specifications of the Taylor-type rules examined in thisarticle differ somewhat from the Taylor rule,although they represent the same general framework for policy. The remainder of this sectiondiscusses specification details of the Taylor ruleand alternative reasonable assumptions about timing, weights, smoothing, and measurement thatmay be made in Taylor-type rules.In the Taylor-type rules examined in this article,the timing of the economic variables on whichfunds rate settings depend is different than inTaylor’s specification. The Taylor rule recommendssetting the federal funds rate according to the
8contemporaneous output gap and the inflationgap over the previous four quarters. However,this specification inappropriately assumes thatthe central bank knows the current quarter valuesof real GDP and a price index when setting thefederal funds rate for that quarter (McCallum1998a,b; Orphanides; McCallum and Nelson). Inthe United States, the first (or advance) release ofreal GDP data for each quarter is not availableuntil roughly a month after the end of that quarter.The second (or preliminary) release is not available until roughly two months after the end of thatquarter. And, the third (or final) release is notavailable until roughly three months after the endof that quarter. In addition, historical data may berevised with the annual revisions of the NationalIncome and Product Accounts data, or with theless frequent comprehensive revisions.8To partially address the timing problem, thisarticle assumes that the federal funds rate in agiven quarter is set according to the output gapand the inflation gap in the previous quarter.Lagging output gap and inflation data by onequarter is a common practical approach to dealingwith lags in the release of data (Stuart).9 However,because this article uses the version of historicaldata available at the start of 1999, even rule recommendations based on lagged data will likelydiffer from those based on real-time data, that is,the version of the data actually available duringthe quarter of the policy decision (McNees;Orphanides; Ghysels, Swanson, and Callan).The second potential difference betweenTaylor-type rules and the Taylor rule is in theweights embedded in the inflation and outputgap adjustments. The weights represent the responsiveness of monetary policy to deviations ofinflation from the inflation target and deviationsof output from potential output. In the Taylorrule, the output and inflation gaps are each multiplied by a weight of 0.5, but Taylor noted a lack ofconsensus about the size of the weights in policyrules. This article explores rule recommendationswith weights of 0.5, but also estimates Taylor-FEDERAL RESERVE BANK OF KANSAS CITYtype rules to see if alternative weights are moreconsistent with historical policy.10The third potential difference is that Taylortype rules may account for smoothing behavioron the part of the Federal Reserve. Many analysts have noted that the Federal Reserve has atendency to smooth movements of the funds rate(Goodfriend; Orphanides; Clarida, Gali, and Gertler1998). Concern about the stability of financialmarkets may lead the Federal Reserve to smoothfunds rate changes (McNees).11 Smoothing mayalso indicate responsiveness of policy actions toinflation and output gaps observed over severalquarters rather than just a single quarter. Alternatively, smoothing may be justified when theeconomic impact of changes in the funds rate isuncertain (Sack). Smoothing can be incorporated in a Taylor-type rule by assuming that theFederal Reserve puts some weight on the previouslevel of the funds rate in addition to the inflationand output gaps when deciding on the currentlevel of the federal funds rate. By contrast, theTaylor rule provides recommendations for federal funds rate settings which depend on the output gap and inflation gap but not on the previouslevel of the federal funds rate.The final dimension by which the Taylortype rules analyzed in this article differ fromTaylor’s 1993 implementation is in the measurement of inflation and the output gap. The question of which measure of inflation policymakersshould attempt to stabilize may not be as simpleas it seems. Often the level and direction ofinflation movements differ for different measures of inflation. Furthermore, in face of divergent movements, justifying a given choice ofinflation measure may prove difficult.The Taylor rule uses as its measure of inflationthe percent change in the price deflator for GDPover the previous four quarters. This article considers four alternative inflation measures—CPIinflation, core CPI inflation, GDP price inflation,and expected inflation (Chart 1). CPI inflation is
ECONOMIC REVIEW l SECOND QUARTER 19999Chart 1INFLATION MEASURESPercent7Percent76655Core CPIinflation4Expectedinflation32CPIinflation43GDP priceinflation211001983 1984 1985 1986 1987 1988 1989 1990 1991 1992 1993 1994 1995 1996 1997Sources: Bureau of Labor Statistics, Bureau of Economic Analysis, Federal Reserve Bank of Philadelphia.measured as the percent change in the consumerprice index over the previous four quarters. CoreCPI inflation is measured as the percent change inthe consumer price index excluding food andenergy over the previous four quarters. GDP priceinflation is measured as the percent change in thechain price index for GDP over the previous fourquarters.12 And, expected inflation is measured asthe forecast of the percent change in the chainprice index for real GDP over the next four quartersas reported by the Survey of Professional Forecasters.These four measures represent both backwardlooking and forward-looking measures of inflation. The first three inflation measures are backward-looking in that they describe inflation over atime period that has already past. By contrast, thefourth inflation measure is forward-looking inthat it describes what a collection of professionalforecasters expect inflation to be over a futuretime period. This last measure provides a directmethod to introduce forward-looking policy.13Expected inflation was included in the analysisbecause many analysts and policymakers arguethat policy should be forward-looking, with fundsrate settings based on expected future inflationrather than on past inflation.14Multiple measures of the output gap are considered because policymakers frequently commenton difficulties in assessing the output gap.15 Thesix measures of the output gap considered in thisarticle are shown in Chart 2. Each output gap isthe percentage difference between real GDPand an estimate of potential real GDP. The six
10FEDERAL RESERVE BANK OF KANSAS CITYChart 2OUTPUT -6DRI-6-8Recursive-8-10-10-12-121983 1984 1985 1986 1987 1988 1989 1990 1991 1992 1993 1994 1995 1996 1997measures of the output gap differ according to estimates of potential real GDP. The measures werechosen because they include different approaches to estimating potential real GDP andcan be easily obtained or easily estimated.16 Themeasures cover a broad range of sources, including a government agency (the CongressionalBudget Office, or CBO), two international institutions (the International Monetary Fund, or IMF,and the Organisation for Economic Cooperationand Development, or OECD), and a corporationthat produces commercial forecasts (Standard &Poor’s DRI). These four measures are labeled bydata source—CBO, IMF, OECD, and DRI, respectively. Two other measures are based on estimatesof potential real GDP constructed using standardprocedures. These measures are labeled Taylorand Recursive—the former because it provides areasonably close approximation to the definitionof the output gap used by Taylor, and the latterbecause it represents a “recursive” version of theformer. More details on the measures of the output gap are provided in Appendix A.II. ARE RULE RECOMMENDATIONSROBUST?This section investigates the robustness of rulerecommendations by examining the sensitivityof Taylor-type rule recommendations to alternative assumptions. Investigating the robustness ofrule recommendations can be done by examining the range of rule recommendations thatwould result across various measures of inflation and the output gap, alternative estimates ofthe equilibrium real rate, or different choices ofweights. The range of rule recommendationsmay be interpreted, for instance, as the range ofrecommendations provided to a policymaker bya group of advisors, each using a Taylor-type
ECONOMIC REVIEW l SECOND QUARTER 199911Chart 3THE RANGE OF TAYLOR-TYPE RULE RECOMMENDATIONSFOR DIFFERENT MEASURES OF INFLATION AND THE OUTPUT GAPPercent12Percent12Federalfunds rate1010886Taylor64422001983 1984 1985 1986 1987 1988 1989 1990 1991 1992 1993 1994 1995 1996 1997Note: The shaded area reflects the range of rule recommendations based on recommendations calculated for each of the six measures ofthe output gap and each of the four measures of inflation. In each quarter, the maximum of the range corresponds to the maximum of the24 rule recommendations, and the minimum of the range corresponds to the minimum of the 24 rule recommendations. Taylor recommendations were calculated by the author using the Taylor rule in (1) and the latest version of data for real GDP and the GDP chain priceindex available in December 1998. These recommendations were based on the Taylor output gap described in Appendix A.Sources: Board of Governors of the Federal Reserve System, author’s calculations.rule, but each having a different view about thespecifics of the rule.17 The analysis in this articleis limited to comparing operational rules, so thetiming adjustment discussed in the previous section is used—measures of the output gap andinflation are for the previous quarter.How robust are rule recommendations toalternative measures of inflation andalternative estimates of the output gap?The Taylor rule was based on specific choicesof inflation and output gap measures. As discussed in the previous section, other reasonablemeasures of inflation and the output gap are avail-able. To assess how robust rule recommendations are across alternative measures of inflationand the output gap, recommendations of the following rule are ex
How Useful Are Taylor Rules for Monetary Policy? By Sharon Kozicki Over the past several years, Taylor rules have attracted increased
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Nov 25, 2008 · In this paper, we examine out-of-sample exchange rate predictability with Taylor rule fundamentals. The starting point for our analysis is the same as for the Taylor rule model of exchange rate determination, the Taylor rule for the foreign country is subtracted from the Taylor rule for the United States (the domestic country).
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