Taylor Rule Provides Clues to Future Short-Term Rates

March 27, 2014 | Christopher Caparelli, CFA, Partner

Developed by Stanford economist John Taylor in 1992, the Taylor Rule is a mathematical model designed to estimate the level of short-term interest rates consistent with the Federal Reserve’s mandate to promote price stability and full employment. In making its prediction, the model measures current inflation and unemployment data against a set of ideal targets. Currently, the model utilizes the Fed’s stated inflation target of 2% and an unemployment rate of 5.6% as the ideals for a healthy economic environment.

Prior to the great recession, the output of the Taylor Rule proved to be fairly accurate in predicting short-term interest rates. As the financial crisis deepened, however, the Taylor Rule began to suggest that a negative level of short-term rates would be necessary in order to restore economic growth. Bound by zero as the floor for interest rates, the Fed was unable to lower short-term rates to meet the level prescribed by the Taylor Rule. With further interest rate decreases no longer an option, the Fed turned to quantitative easing as a means to further loosen monetary policy. Five years later, with the U.S. economy on more stable ground, the level of short-term rates prescribed by the Taylor Rule has once again turned positive. Not surprisingly, the Fed has begun to slow the pace of quantitative easing with the program scheduled to come to an end altogether later this year. As investors eye Fed clues for the future path of short-term rates, consider the Taylor Rule as a useful guide.