Taylor Rule

Formula and meaning

Taylor (1993) summarized Federal Reserve rate setting in a simple equation: i = r* + π + 0.5(π − π*) + 0.5(y − y*). Here i is the nominal policy rate, r* the neutral real rate (assumed by Taylor to be 2 percent), π inflation over the past year, π* the inflation target (2 percent), and y − y* the output gap, the percentage deviation of real GDP from potential. If inflation runs 1 percentage point above target, the rate should rise by 1.5 points; if output is 1 percent below potential, the rate should fall by 0.5 points. Taylor showed that this simple equation tracked the Fed's actual rate path from 1987 to 1992 remarkably well. It has since become a benchmark that central banks, market participants and researchers use to judge the stance of monetary policy.

The Taylor principle and rules versus discretion

The requirement that the nominal rate rise by more than one-for-one (1.5 points) when inflation rises by one point is called the Taylor principle: only then does the real rate rise enough to restrain demand and stabilize inflation. Clarida, Galí and Gertler (2000) found that the pre-1979 Fed violated the principle, contributing to the Great Inflation of the 1970s, and that adherence after Volcker brought stability. The discussion connects to Kydland and Prescott's (1977) time-inconsistency problem: under rational expectations, discretionary policy breeds an inflation bias, so a pre-committed rule is better. Unlike Milton Friedman's (1960) k-percent money growth rule, the Taylor rule uses the interest rate as its instrument and responds to economic conditions. Woodford (2003) formalized the optimality of such rules in New Keynesian models.

Limits and practical use

The Taylor rule has several limits. Orphanides (2001) showed that real-time output-gap estimates available to policymakers differ greatly from later revisions, so fits based on revised data overstate how well the rule describes policy. The neutral rate r* is unobservable and shifts over time; Laubach and Williams (2003) estimates indicate it fell sharply after 2008. Svensson (2003) argued that forecast-based inflation targeting outperforms simple rules. Taylor (2007) criticized the Fed for holding rates well below the rule in 2002–2005 and fueling the housing bubble, while Bernanke (2015) replied that the gap disappears with other inflation measures and coefficients. And when the rule prescribes negative rates at the zero lower bound, it cannot be followed literally. Even so, the Fed includes the Taylor rule and its variants as reference points in its semiannual Monetary Policy Report.

FAQ

What is the Taylor rule in simple terms?

It is a simple formula telling a central bank how much to raise rates when inflation is above target or the economy overheats, and how much to cut them when inflation is low or the economy is weak.

What is the Taylor principle?

When inflation rises, the nominal rate must rise by even more so that the real rate goes up and inflation stabilizes. In the Taylor rule this is the 1.5 coefficient.

Sources reviewed: 2026-10-26

References

1. Taylor, J. B. (1993). Discretion versus policy rules in practice. Carnegie-Rochester Conference Series on Public Policy, 39, 195–214.
2. Taylor, J. B. (1999). A historical analysis of monetary policy rules. In J. B. Taylor (Ed.), Monetary Policy Rules (pp. 319–348). Chicago: University of Chicago Press.
3. Kydland, F. E., & Prescott, E. C. (1977). Rules rather than discretion: The inconsistency of optimal plans. Journal of Political Economy, 85(3), 473–491.
4. Clarida, R., Galí, J., & Gertler, M. (2000). Monetary policy rules and macroeconomic stability. Quarterly Journal of Economics, 115(1), 147–180.
5. Woodford, M. (2003). Interest and Prices: Foundations of a Theory of Monetary Policy. Princeton: Princeton University Press.
6. Orphanides, A. (2001). Monetary policy rules based on real-time data. American Economic Review, 91(4), 964–985.
7. Laubach, T., & Williams, J. C. (2003). Measuring the natural rate of interest. Review of Economics and Statistics, 85(4), 1063–1070.
8. Taylor, J. B. (2007). Housing and monetary policy. NBER Working Paper No. 13682.
9. Bernanke, B. S. (2015). The Taylor rule: A benchmark for monetary policy? Brookings Institution blog, April 28.
10. Svensson, L. E. O. (2003). What is wrong with Taylor rules? Journal of Economic Literature, 41(2), 426–477.
11. Friedman, M. (1960). A Program for Monetary Stability. New York: Fordham University Press.
12. Board of Governors of the Federal Reserve System (2024). Monetary Policy Report: Monetary policy rules. Washington, DC.
13. Galí, J. (2015). Monetary Policy, Inflation, and the Business Cycle (2nd ed.). Princeton: Princeton University Press.