Taylor Rule
The Taylor rule is a formula, introduced by economist John Taylor in 1993, that suggests a policy interest rate based on the neutral rate, current inflation, the gap between inflation and its target, and the gap between output and its potential.
How high should interest rates be? Central banks weigh dozens of data points, but the Taylor rule boils the question down to a simple equation: raise rates when inflation is above target or the economy runs hot, cut them when the opposite is true. It is not a law the Fed must follow, but it is a widely used benchmark. This entry explains the formula, a worked example and its limits.
- Category
- Fundamentals and Macroeconomics
- Reading time
- 4 min
- Also called
- Taylor's rule, Monetary policy rule, Taylor rule formula
- Updated
The Taylor rule in plain words
John Taylor introduced the rule in a 1993 paper as an equation prescribing a policy rate; many modified versions have since been used.1
The Fed's version: rate = neutral real rate + inflation + 0.5 × (inflation − target) + 0.5 × (output − potential output).2
Rules like this prescribe a policy rate linked to how far inflation is from the 2% objective.2
How to calculate the Taylor rule, step by step
Neutral real rate
The longer-run inflation-adjusted rate. See Real Yield.
Add current inflation
Converts to a nominal rate. See Inflation.
Inflation gap
0.5 × (inflation − 2%).
Output gap
0.5 × (real GDP − potential GDP) in %. See Output Gap.
Add them up
The suggested policy rate.
Compare with the actual rate
Is policy tight or loose? See Interest Rate.
Worked examples
Example 1 — Inflation above target
6% suggestedNeutral real rate 1%, inflation 4%, target 2%, output gap 0.
| Base | 1% + 4% = 5% |
| Inflation gap | 0.5 × (4% − 2%) = 1% |
| Suggested rate | 5% + 1% + 0 = 6% |
Under the Taylor rule, inflation above target pushes the prescribed rate higher.2
Example 2 — Weak economy
1% suggestedNeutral real rate 1%, inflation 2%, target 2%, output gap −4%.
| Base | 1% + 2% = 3% |
| Output gap term | 0.5 × (−4%) = −2% |
| Suggested rate | 3% − 2% = 1% |
A negative output gap lowers the prescribed rate, pointing to easier policy. See Rate Hike and Rate Cut.
Example 3 — Policy looks too loose
Below the ruleThe rule suggests 5.5%, but the actual fed funds rate is 4%.
| Gap | 5.5% − 4% = 1.5 points |
| Reading | Policy looser than the rule |
Analysts compare actual rates with rule prescriptions; the Atlanta Fed publishes such comparisons.1
Taylor rule vs balanced-approach rule
| Aspect | Taylor rule | Balanced-approach rule |
|---|---|---|
| Inflation gap weight | 0.5 | 0.5 |
| Output gap weight | 0.5 | 1.0 |
| Response to slack | Moderate | Stronger |
| Source | Taylor (1993) | Fed staff alternatives |
How the Taylor rule is used
Judging Fed policy
Is it tight or loose? See Federal Reserve.
Forecasting rates
Traders project rate paths. See Fed Funds Futures.
Bond markets
Rate expectations drive yields. See Yield Curve.
Comparing central banks
The same idea applies elsewhere. See Central Bank.
Advantages and disadvantages
Advantages
- Simple, transparent benchmark.
- Links rates to inflation and growth.
- Widely used by analysts and central banks.
Disadvantages
- Neutral rate and potential output are unobservable.
- Different inputs give very different answers.
- Ignores financial stability and the lower bound.
Going deeper
Read as far as you need. Each level builds on the one before it.
Not a law
Beginner
The Fed reviews a range of illustrative rules from research, including the Taylor rule; none is followed mechanically.2
Many versions
Intermediate
Modern variants swap the inflation measure, use a time-varying neutral rate instead of Taylor's original 2%, or use the unemployment gap.1
The lower bound
Advanced
When rules prescribe rates below zero, central banks face an effective lower bound near zero, and adjusted rules keep rates low for longer afterwards.2
Common mistakes
Treating it as the Fed's formula
It is a benchmark only.
Ignoring input uncertainty
Small changes in inputs shift the answer.
Using the wrong inflation measure
The Fed targets PCE inflation. See PCE Inflation.
Forgetting the sign of the output gap
Negative gaps lower the rate.
Check your understanding
Test yourself before moving on. Each answer comes with an explanation.
Key points to remember
- The Taylor rule suggests a policy rate from inflation and output.
- It was introduced by John Taylor in 1993.
- Higher inflation or a hot economy means a higher rate.
- It is a benchmark, not a rule the Fed must follow.
- Inputs like the neutral rate are uncertain.
Frequently asked questions
Does the Fed follow the Taylor rule?
What is the neutral rate?
Where can I see current prescriptions?
Further learning
- Federal Reserve
Who sets US rates.
- Output Gap
A key input.
- PCE Inflation
The Fed's inflation measure.
- Fed Funds Futures
Market-implied rate paths.
Sources
This article is written in our own words. The sources below support the specific facts, rules and figures marked with a number in the text. Links open the original publisher’s page.
- Federal Reserve Bank of Atlanta. Taylor Rule Utility (opens in a new tab) Checked .
- Federal Reserve Board. Policy Rules and How Policymakers Use Them (opens in a new tab) Checked .
Educational content, not financial advice. Examples use hypothetical prices and simplified costs; actual fees, margin rules and regulations vary by broker, market and country. We are not affiliated with any publisher linked above. Last reviewed . Report an error or request a source credit.