Deconstructing The Taylor Rule

By Chandrashekar (Chandra) Tamirisa, (On Twitter) @c_tamirisa

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John Taylor, the Stanford University economics professor and former Undersecretary of Treasury for International Affairs, wrote what has become a landmark paper since 1993, the year former president Bill Clinton took office. It was called “Discretion versus policy rules in practice.” The essence of the subject of the paper was a technical discussion of how to fit the data of Federal Reserve policy over time to a curve: to a regression equation. The paper had done such an extraordinary job of tracking Fed policy and explaining it, that it became a benchmark to both expect Fed policy and to judge it in the subsequent years. It had become a rule by which monetary policy can be reasonably expected to be made by any central bank as if to say: you made it this way all along, so follow my rule and make it the same way in the future and the world will be alright.

Without getting into the mathematical details of the Taylor Rule, it would suffice to say that the variables in the equation are the interest rate that the Federal Reserve sets based on the current inflation, the interest rate the economy really experiences, the inflation the Fed likes and its deviation from the current inflation, the deviation of the current economic growth rate from the growth rate that is tolerable by the economy without raising prices for the same goods and services because businesses have to spend more to invest to meet the higher demand and because the ensuing higher demand for the inputs into production can raise their prices and eventually consumer prices if production technologies and processes are not more efficient. Many variants of the Taylor Rule have proliferated in the literature since 1993.

Before John Taylor, two well-known American economists, Irving Fisher and Milton Friedman, had more parsimoniously dealt with the same problem. Fisher had lived and done most of his work before the Great Depression and during the period of industrial ferment in America in the late 19th and the first half of the 20th centuries. He was among the earliest economists of the American Economic Association (AEA) after it was founded in 1885. And he had given considerable thought to interest rates and prices and formulated his findings in a simple mathematical relationship that bears his name to quantitatively describe the relationship between the interest rate everybody knows (nominal interest rate), inflation (the deterioration of the purchasing power of money) and the interest rate they actually experience because of inflation (real interest rate).

The Fisher equation simply says that if you subtract inflation from the nominal interest rate, you get the real interest rate. Meaning, because some depreciation of the value of money is always the case and is unavoidable because of scarcity, people really do not pay as much in interest as they think they do. More simply put, the higher the inflation, the cheaper are the loans that people take out. When prices do not change and inflation is zero, they pay in interest really as much they think they are paying. When prices fall, as was the case during the Great Depression that came close to Fisher’s death, inflation is negative and therefore adds to the interest rate people are quoted, making their loans more expensive. The Fisher equation, as is, is the first part of the Taylor Rule.

Milton Friedman, the founding modern monetary economist, had later respecified the Quantity Theory of Money (QTM), which has its roots in classical philosophy. QTM, like the Fisher equation, another simple mathematical relationship which equates the product of the quantity of money supplied and the rate at which that money changes hands and the product of the overall price level in an economy and the rate of growth of the economy, as it is computed being since World War II.

Beyond the academic interest surrounding that equation, its meaning is profound: it says that the amount of money supplied produces both inflation and economic growth. The challenge is to minimize inflation while increasing growth, because both more growth and less growth can cause inflation. More growth causes inflation because the prices of resources will rise with scarcity and less growth will cause it because without making more and diverse real things, the same things that are made by the economy will cost more causing inflation if money growth is not reduced when the economy is not innovating to produce more. And economics has no way to make an economy innovate, at least not as yet (Joseph Schumpeter provides a compelling explanation of the innovation dynamics in a free market economy under limited government, but does not provide a mechanism to modulate innovation).

Often, as Friedman himself did, the focus had always been on the relationship between money supply and its causation of inflation. He did not want, along the lines of classical thinking that goes back 2 centuries before the quantity theory was picked up by American economists, more money chasing the same goods causing money to become cheaper because the same goods cost more. Still, from Friedman’s restatement of QTM in 1956 to determine the optimal money supply, mathematically relates the change in the price level in the original quantity theory which is the macroeconomic definition of inflation to the quantity of money and national output or income.

But all of this is pure monetary theory even if the purpose of theoretically trying to determine optimum money supply is to make monetary policy. The classical philosophers and economists did not particularly care about modulating money supply to control the economy. They saw the relationship between money and economic growth as fairly linear with economic cycles being caused by other factors in a free society.

This view is surprisingly correct, on average. The growth of national output is indeed a linear, straight line sloping upward. Milton Friedman himself had subscribed to this view, but his attempt to determine the optimal money supply was more about trying to determine the fixed extent to which the monetary hose must be left open by the government, year after year for the economy to take care of itself, not to either shrink it or expand it based on the economic circumstances, meddling with it without understanding it, contributing to the causation of business cycles even if the intent is business cycle stabilization. If politics are factored in, to sympathize with the time consistency motivation behind John Taylor’s seminal paper, business cycle stabilization could fast turn into a cover for the political manipulation of the economy, even if the capacity to do so is inadequate.

That was indeed the world in which Irving Fisher had lived as the United States evolved from the railroads to the automobiles at a feverish pace over a period of about 75 years, with a few ups and downs until the Federal Reserve founded in 1913 tried to fine tune money supply after 1929 by reducing its supply, not once but twice in 1933 and 1936, to prevent more money chasing the same stocks, thinking that that could have caused the asset prices to appreciate. The economy would perhaps have been better off had it done nothing, opening the monetary spigot at a fixed rate of money growth and leaving the rest to the economy.

Still, the temptation to produce prosperity by raising money growth is justifiable if the money is used to produce more food, more machinery, more innovation and more support to both agriculture and the industry through the related services. This temptation is the addition made by John Taylor to the Fisher equation to come up with his rule. The threat of targeting the rate of change of prices, the Taylor Rule implicitly assumes, can make the economy produce more by using money more efficiently.

John Taylor hopes with his equation to raise the utility of money through the stick of an inflation target. The tighter the target, the more pressure on the producers to use the money they have been supplied more efficiently to raise the economy’s speed limit. However, he does not say if the economy can indeed do so because economics has no mechanism to ensure that that can happen to the best of the ability of the various economic actors and in good faith. After all, they could seek short term profits and increase inflation to the Fed’s target level and keep doing so until the circumstances force them to work hard, with each cycle of the rise and fall of the Fed’s interest rate depressing the rate of growth of the national output over time until that can no longer be possible without causing economic decline. This behavior is verifiable in economic data since Paul Volcker began targeting inflation in 1979: the U.S economy doubled under Reagan and Bush, grew by about 75 per cent under Clinton and around 30 per cent under Bush and is in stagnation thus far under Obama, if the trend of growth rate is measured in decade-long intervals since 1979, albeit the intermediate short-term fluctuations both up and down.

Taylor’s addition to the Fisher equation will be zeroed out when inflation and output are at target, leaving behind the Fisher equation. Because inflation target is the central bank’s choice, the economy will end up determining its speed limit and John Taylor did not contribute anything new to economic knowledge, either in theory or in practice, beyond what has already existed for about 75 years.

The Taylor Rule may track Fed policy well with either an implicit inflation target (which the Fed has) or an explicit inflation target (which the Fed does not yet have), but the rule itself does not help grow the economy until the old-fashioned money-for-real investment values return to the economic culture to see derivative financial assets such as stocks and bonds and all else as subordinate to real assets. The prices of financial assets and real earnings of the firms upon whose performance those assets are predicated must be in balance for an economy to be on a balanced growth path.

The only purpose of money supply by fiat is to grow the real economy as efficiently as it can while providing a quality life for the workers. Targeting inflation alone will not do that job.


About Chandrashekar (Chandra) Tamirisa
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