09-26-2024
We now have all of the pieces needed to provide a benchmark for the Federal Reserve’s policy rate — the Taylor Rule. While it is called a “rule,” it should be viewed as a guideline for where the Fed should set its policy rate given current economic conditions and absent any other considerations. The Taylor Rule is a good starting point for thinking about where the Fed’s policy rate should be rather than an ending point.
The Taylor Rule starts with the “neutral” Fed policy rate — the natural rate of interest plus 2 percent (the Fed’s target inflation rate). To reflect the inflation portion of the Fed’s dual mandate and the Taylor Principle, we add to the neutral policy rate the current estimate of the inflation gap multiplied by a number between 1 and 2. Finally, to reflect the maximum sustainable employment portion of the Fed’s dual mandate we further add the current estimate of the unemployment gap multiplied by a number between 0 and 1. These three components summed together provide guidance for where the Fed’s policy rate should be given current economic conditions as reflected in the inflation and unemployment gaps. The Fed would then adjust the policy rate up or down based on any considerations not well captured by these two gaps.
As an illustration, let’s construct a Taylor rule using a value of 1.5 to multiply the inflation gap and a value of 0.5 to multiply the unemployment gap. Based on my last post, we can use the Fed’s September Survey of Economic Projections to select a value for the neutral policy rate. We can focus on the middle half of the Fed survey responses where the reported neutral rates ranged from 2.75 to 3.37 percent. The midpoint of this range is around 3 percent. If we use the Dallas Fed’s trimmed mean PCE (July 2024) as our measure of underlying inflation, the inflation gap is 0.7. Using the CBO’s estimate of the natural rate of unemployment of 4.3 percent, the unemployment gap is essentially zero—at 0.001. Using our selected values of 1.5 and 0.5 to scale these two gaps we get a suggested Fed policy rate of around 4.05 percent.
This version of the Taylor rule indicates that even after the Fed’s 50 basis point reduction in its policy rate at the September meeting, its policy rate is still at least 75 basis points above this benchmark. If the considerations that caused the Fed to delay cutting its policy rate are resolving, then this would indicate that there is still room for further cut in the policy rate even if economic conditions as captured by the inflation and unemployment gaps do not change over the near term. Put differently, other considerations aside, this version of the Taylor rule suggests that the Fed does not need to see further slowing in underlying inflation to continue to cut its policy rate.
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.
