The Taylor Rule is a monetary policy guideline proposed by Stanford economist John B. Taylor in his 1993 paper "Discretion versus Policy Rules in Practice." It prescribes how a central bank should adjust its short-term nominal interest rate in response to two variables: the deviation of actual inflation from a target rate, and the deviation of actual output (or employment) from its potential level (the output gap).
In its original form, the rule is written as:
i = r* + π + 0.5(π − π*) + 0.5(y − y*)
where i is the nominal policy rate, r* is the assumed equilibrium real interest rate (Taylor used 2%), π is the current inflation rate, π* is the inflation target (Taylor used 2%), and (y − y*) is the output gap in percent. The coefficients of 0.5 mean the central bank responds equally and meaningfully to both inflation and output deviations.
A key implication is the Taylor principle: when inflation rises by one percentage point, the nominal rate should rise by more than one point so that the real interest rate increases, tightening policy. Failure to satisfy this principle is widely blamed for the stagflation of the 1970s.
The rule is used in three main ways:
- As a descriptive benchmark for how central banks like the U.S. Federal Reserve, ECB, and Bank of England have historically behaved.
- As a prescriptive tool for evaluating whether current policy is too loose or too tight.
- As a baseline in DSGE models and academic forecasting.
Critics, including former Fed Chair Ben Bernanke, argue that the rule is too mechanical, ignores financial stability, and is sensitive to unobservable inputs like the equilibrium real rate and potential output. Taylor himself has argued the Fed deviated from the rule in 2003–2005, contributing to the housing bubble — a contested claim. Variants such as the "balanced-approach rule" (with a coefficient of 1.0 on the output gap) are published quarterly in the Fed's Monetary Policy Report.
Example
In its semiannual Monetary Policy Report, the U.S. Federal Reserve regularly publishes Taylor Rule prescriptions alongside actual federal funds rate decisions to benchmark its policy stance.