06-16-2026
The Federal Open Market Committee (FOMC) appears to have made a pivot away from further near-term policy rate cuts to holding its nominal policy rate fixed while assessing the data as it comes in. An important point for calibrating monetary policy is that what matters for inflation is not the Fed’s nominal policy rate but the real policy rate.
Professor John Taylor advocated that to stabilize inflation a central bank needs to adjust its nominal policy rate more than one for one with changes in inflation. That is, if inflation is rising a central bank needs to increase its real policy rate by raising its nominal policy rate by more than the increase in inflation. This is known as the “Taylor Principle.”
How has the Fed been doing of late in putting Taylor’s Principle into practice? The chart below shows 12-month headline PCE inflation and the real effective Federal Funds rate (FFR). The chart begins in July of 2023 when the Fed stopped raising the nominal FFR.
In the summer of 2023, inflation was on a downward trajectory, so holding the nominal policy rate constant over the second half of 2023 and into the first half of 2024 resulted in further policy tightening as the real effective FFR continued to rise. It appeared at this point in time that the Fed was on track to bring inflation back down to its 2 percent target.
However, in September of 2024 (first vertical dashed line) the Fed pivoted and began to cut its nominal policy rate in order to buy insurance against possible future weakening of the labor market. The last policy rate cut was in December 2025. These policy rate cuts resulted in a decline in the real FFR. As a consequence, the progress on bringing down inflation at first stalled and then reversed.
In November 2025 (second vertical dashed line), the outbreak of hostilities in Iran and the ensuing disruption to energy markets led to a sharp increase in PCE inflation. Ignoring the Taylor Principle, the Fed has continued to hold its nominal policy rate steady allowing the real effective FFR to continue to decline and in April to become negative.
While expectations for further nominal policy rate cuts have evaporated, they have shifted instead to holding the near-term policy rate steady. Markets are assessing that a rate increase by the end of the year is a coin toss. The Fed has now missed its inflation target on the high side for five years. Letting its real policy rate go negative is a recipe for extending this poor inflation performance into the indefinite future. The belief that inflation will decline back to 2 percent with a very accommodative monetary policy stance relies more on hope than experience.
The Taylor Principle indicates that the Fed should be increasing its real policy rate in response to the current inflation pressures. Holding its nominal policy rate constant is not the same as keeping the degree of policy restraint constant. As markets and the public see the Fed continuing to ignore the Taylor Principle, the risk is that they adjust their inflation expectations higher. This will only further complicate the task of bringing inflation back down to 2 percent. While Mark Twain was not a monetary policy expert, his advice should be taken seriously by monetary policymakers: “To stand still is to fall behind.”
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. He regularly contributes insightful posts about financial markets to Daniels Insights.
