Could an equation do a better job at setting a target interest rate than the Fed?
ELISSA NADWORNY, HOST:
The Federal Reserve, specifically a Fed committee, meets several times a year to set interest rates. Lately, they've been raising rates to bring down historically high inflation. But what if a formula could do that work and maybe even do a better job? Darian Woods and Mary Childs from our daily economics podcast The Indicator explain the Taylor Rule.
DARIAN WOODS, BYLINE: The Taylor Rule is a formula that can automate how much to raise or lower interest rates to keep inflation steady. And its origins start in the 1970s. Back then, American monetary policy was a mess. Inflation was out of control, and unemployment was high.
MARY CHILDS, BYLINE: John Taylor was an economist then, recently out of his Ph.D. He was working at the Council of Economic Advisers under President Ford.
JOHN TAYLOR: We had money growth high, money growth low. It didn't seem like the way we should be conducting policy. So I started with, how can we conduct policy in a more understandable way?
WOODS: John was looking for a way to guide Fed officials towards keeping the economy growing steadily - not too much inflation, not too much unemployment.
CHILDS: But a lot of the recipes out there giving models for how the central banks should raise or lower interest rates had a lot of inputs and equations. John didn't think these models would work for policymakers.
TAYLOR: Gee, this recipe is so complicated. Can't we simplify it? We want it to be available for everybody.
WOODS: And in the early 1990s, John developed his recipe, which was essentially this. Raise interest rates by more than the spike in inflation. So we've got this target for the Fed, usually. This is the 2% inflation target. And so let's say you have inflation bubbling along at 2%, but then one day it spikes up to 3%. And then the Taylor Rule says that you would raise interest rates by 1 1/2 percentage points. And you also take into account how overheated or undercooked the wider economy is as well.
CHILDS: And those two factors together, inflation and the state of the economy - that's more or less it. That's the Taylor Rule.
TAYLOR: I didn't think it'd be so important or useful. That's for sure.
CHILDS: John crunched the numbers for his rule, and he found that it described fairly closely what the Federal Reserve had actually done in the 1980s and would go on to do in the 1990s.
WOODS: And when the Fed had deviated from the Taylor Rule, that was the 1970s, when inflation got so high that the Fed had to crash the economy in the early '80s to stamp it out. It was also in the early 2000s, when low interest rates contributed to massive housing price growth, fueling the speculative bubble that led to the Great Recession in 2008.
CHILDS: John felt like his historical analysis vindicated the Taylor Rule. If the rule had been followed, maybe we could have avoided those crashes. And as the years go on, John is trying to promote this idea. We have an autopilot for the Fed. We have policy rules. And in his view, policy rules like the Taylor Rule work better than human judgment most of the time.
WOODS: The Taylor Rule does have its critics, notably Janet Yellen, the former Fed chair and now treasury secretary. She points out that, yes, the formula can work a lot of the time. But which indicators are you going to use? Like, is inflation the consumer price index, or is it the Fed's preferred consumption expenditures index? These questions matter a lot. Also, Janet Yellen says that geopolitical events like trade wars might be on the horizon. And these might be things that only a committee of human beings might be able to anticipate. But the Fed did, on its own initiative, start publishing charts twice a year, comparing what it had been doing with interest rates with the Taylor Rule. And John says that has been insightful in this pandemic economy. Under the Taylor Rule, interest rates would have risen to around 7 or 8% last year. And instead, they stayed near zero.
TAYLOR: I'd say right now that most central banks are still behind. It's not like they're rushing to do this.
CHILDS: John is holding out hope that our current high inflation might revive interest in institutionalizing his rule.
WOODS: Taylor's version of the world is a world without human beings. It's just a mathematical formula.
CHILDS: Yeah. Maybe he's right. Maybe we're the problem.
CHILDS: Mary Childs.
WOODS: Darian Woods, NPR News. Transcript provided by NPR, Copyright NPR.