The Taylor Rule

If you were John Taylor, how would you set the base interest rate for U.S. banks?

John Taylor is, of course, the guy who invented the Taylor Rule – a guide the U.S. Federal Reserve could follow in setting the level of the Federal Funds Rate. And recently, he got a bit annoyed with some other guys who had different ideas for what level the Fed should set that base interest rate for U.S. banks, who invoked his rule to justify their preferences.

• Over at Market Beat: WSJ.com’s inside look at the markets, Mark Gongloff reports that Standard Chartered’s David Semmens says that “Based on a strict Taylor-rule calculation, the first effective fed-funds rate increase shouldn’t come until the first quarter of 2013.”
• And over at Business Insider, Art Cashin of UBS reports that Jim Brown of Premium Investor says that “the Taylor rule says the Fed funds rate should be -1.65%” suggesting the need for a QE 2.5.
• But no calculations are provided in either report.
• Over here at Economics One, I can report that the Taylor Rule says that the fed funds rate should now be 1 percent, and I can provide the calculations. Available data (through the 1st quarter) show that the inflation rate is about 1.6 percent (GDP deflator smoothed over four quarters) and the GDP gap is about 4.8 percent (average of San Francisco Fed survey). This implies an interest rate of 1.5 X1.6 + .5X(-4.8) + 1 = 2.4 – 2.4 +1 = 1.0 percent. I am not sure why other reports differ, but at least the coefficients and numbers are here to see and check. Perhaps they are using different coefficients, but David Papell writing at Econbrowser earlier this month showed why the coefficients reported here work well.
• So I think the economy would be better off if the Fed started moving to a higher funds rate now rather than later, and I certainly see no rationale for another round of quantitative easing. Unfortunately, it looks like the Fed will continue with its zero interest rate for a while longer, and traders will continue to debate whether or not there will be a QE3 adding volatility to the market.

So to clear up any confusion in the econoblogosphere about how John Taylor would set U.S. interest rates, our newest tool will help you do Taylor’s math just as he would, so he won’t have to call you out on his blog any more!

Just enter the indicated data in the tool below, and we’ll tell you what John Taylor would do if John Taylor used his rule to set U.S. interest rates:

Using the default data from John Taylor’s blog post, we find that if John Taylor’s Rule were applied to the U.S. Federal Funds Rate today, it would go up from nearly 0% to 1.0%.

And that’s what John Taylor’s Taylor Rule would do.

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