Published on 08-26-2024
In a previous post, I discussed the Taylor Principle as a guide to how Central Banks should adjust their nominal policy rate for changes in underlying inflation. The key insight of the Taylor Principle is that to stabilize inflation Central banks should change their nominal policy rate by more than the change in underlying inflation. A common formulation is that if underlying inflation declines by 1 percentage point the Central Bank reduces its nominal policy rate by 1.5 percentage points. This means that the Central Bank reduces its real policy rate in response to declines in underlying inflation.
The Fed in its communications over the past several meetings has stressed its need to gain more confidence over the future path of inflation before it reduces its nominal policy rate from its current range of 5.25 to 5.5 percent. That is, a key focus of the Fed is its level of inflation uncertainty. How could the Taylor Principle be modified to incorporate uncertainty over underlying inflation?
We can use a nautical analogy to gain some insight. If you are steering a boat and fog sets in reducing your visibility, this creates uncertainty over whether other boats may be approaching unseen thereby increasing the risk of a collision. A commonsense decision is to reduce your speed so that you continue toward your objective but with more caution. You do not stop or worse shift into reverse.
Applying this insight to the Taylor Principle, we can think of adjusting the nominal policy rate by 1.5 times the change in underlying inflation as the appropriate course to take in an environment of normal or low inflation uncertainty. However, if inflation uncertainty is high, you “slow down” by adjusting the reaction to changes in underlying inflation to less than 1.5 (but greater than 1). That is, if underlying inflation is declining but uncertainty is high, you still reduce the real policy rate but by less than if uncertainty was normal. You do not keep the real policy rate unchanged (i.e. “stop”) or worse allow the real policy rate to increase (i.e. “reverse”).
If the Fed were following the Taylor Principle, then uncertainty over the future course of inflation is not a reason given the decline in underlying inflation to have allowed the real policy rate to increase over the past 12 months.
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.
