Economists have spent a lot of time and energy studying how monetary policy should be designed and implemented. Though policymaking remains in a large measure a subjective endeavour, if not an art as some would have it, economists generally agree on the basic principles that should guide central bankers. Back in 1993, John Taylor proposed a rule that incorporated these. It stipulates that the "real" short-term interest rate should be determined by three elements, namely, (1) where current inflation is at relative to the central bank’s target level, (2) how far economic activity is above or below its "full employment" level, and (3) what is the level of the shortterm interest rate that would be consistent with full employment. Accordingly, a central bank should raise interest rates when inflation is above target or when the economy is running above full employment, and vice versa.
Over the years, the Taylor rule has gained a great deal of popularity with economic commentators for two main reasons. First and foremost, it provides a simple framework to work with. Second, it has been demonstrated empirically that variants of the rule based on inflation expectations and output gap, which allow for interest-rate smoothing, explain quite well the behaviour of the Fed target rate during Greenspan’s tenure at the Federal Reserve. This is why we have often referred to the rule in our past discussions of U.S. monetary policy.
Nowadays, with the Fed target rate at the zero bound and the Fed heavily engaged in quantitative easing (QE), the Taylor rule may appear less relevant. However, the fundamental principles on which it is erected remain valid. Consequently, we can still apply the rule to get a feel of just how accommodative monetary policy should be.
