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The "rule" Yellen seems to advocate has become known as the Taylor rule, and it has caught the attention of researchers, policymakers, and the press. In a seminal 1993 paper, John Taylor, the current undersecretary of Treasury, claimed that adhering to a simple rule or strategy whereby the central bank sets the federal funds rate in response to two variables-inflation and deviations from potential output-is a useful way to conduct monetary policy. He maintained that such a rule could keep inflation low and stable without the "go-stop" fluctuations in output that had plagued the economy during the 1970s. Taylor went further and claimed that the actual policy moves made by the FOMC since 1987 are well characterized by such a rule.
Clearly, the FOMC considers a myriad of data when making decisions. Yet many agree that a simple rule like the one Taylor described does approximate the FOMC's actual policy moves over the past 15 years. In what sense is this true? This Economic Commentary explains what the Taylor rule is, discusses how well it predicts the actual federal funds rate, and perhaps gives some insight into why it has sparked so much interest.
* The Taylor Rule
There is a long history in economics extolling the virtues of rules. One reason is that policymakers, just like individuals, sometimes need help sticking to a goal that requires long-term commitment. Rules can help policymakers stick to long-term goals when they arc tempted to deviate from them to gain something good in the short run. Pursuing short-term gain may undermine long-term goals in the same way that rolling over and hitting the snooze button on the alarm threatens one's goal of getting to work on time. But even though rules are effective, policymakers are understandably reluctant to chain themselves to ironclad rules. Despite their reluctance, the Taylor rule has had a big impact in monetary policy circles, as well as economics. Figure 1 suggests why. The Taylor rule seems to track, very successfully, broad policy moves since 1987.
This success seems remarkable because Taylor's rule is so simple: It is set according to only four components.
The first factor is the Fed's long-term inflation target. This is the inflation rate that will prevail on average over...