07-09-2024
Monetary policy affects the economy through its real policy rate, not its nominal policy rate. The “real” policy rate takes inflation into consideration; the “nominal” policy rate does not consider inflation.
A higher nominal policy rate is not necessarily more restrictive than a lower nominal policy rate depending on the level of underlying inflation in each case. Similarly, the Federal Reserve leaving its nominal policy rate unchanged while the underlying inflation rate is changing is in fact a change in monetary policy.
How should the Fed adjust its nominal policy rate to changes in underlying inflation? A key step in answering this question is the “Taylor Principle”— named after Professor John Taylor of Stanford University. Economist Taylor argued that for the Fed to stabilize inflation around its target it should adjust the nominal policy rate more than one-for-one with changes in underlying inflation. That is, if underlying inflation is rising, the Fed should increase the real policy rate. A higher real policy rate makes monetary policy more restrictive and should help to reduce inflation. Similarly, if underlying inflation is falling, the Fed should decrease the real policy rate. This will make monetary policy less restrictive.
In practice, a common application of the Taylor Principle adjusts the nominal policy rate by a factor of one and a half times the change in underlying inflation. This would imply that if over a period of time underlying inflation has fallen by one percentage point, then the Fed would reduce its nominal policy rate lower by one and a half percentage points. To put the Taylor Principle into practice, one must select a measure of underlying inflation. More to come on that.
Joseph Tracy is a Distinguished Fellow at Purdue University’s Daniels School of Business and a nonresident senior fellow at the American Enterprise Institute. Previously he was executive vice president and senior advisor to the president at the Federal Reserve Bank of Dallas.
