Taylor Rule

The Taylor rule is a proposed formula for how central banks should alter interest rates in response to changes in macroeconomic variables.

The Taylor rule can be expressed in the following equation:

R_fed = R_real + Inf + 0.5i +0.5y

R_fed is the interest rate set by the central bank. R_real is the assumed equilibrium real interest rate, Inf is the rate of inflation, i is the inflation gap (the difference between the actual inflation rate and the target inflation rate), y is the output gap (the difference between the actual real GDP and the potential GDP, i.e. the GDP corresponding to full employment).

The formula may seem complicated, but assuming both the target rate of inflation and the equilibrium real interest rate at 2 percent, we get a simplified form of the equation:

R_fed = 1.5Inf + 0.5y + 1

Thus, the Taylor rule is actually a simple recipe for interest-rate policy. When the inflation rate increases (decreases) by 1 percentage point, the central bank should raise (cut) the interest rates by 1.5 percentage point, while if the output gap falls to -1 percent, the central bank should lower the interest rate by half a percentage point.

Although the formula is simple, it hides many simplifying assumptions and drawbacks. First, the equation does not take into account other factors than inflation and the output gap. Second, it is not clear which data should be used by the central bank: real-time data, revised data or projected data. How should we measure inflation and the output gap, which is non-observable, actually? Hence, as central banks have many options here, there are actually numerous Taylor rules, as “lack of constant parameters and vagueness of variables imply that there is no single Taylor rule”.

Taylor Rule and Gold

After Trump’s victory in the U.S. presidential election in November 2016, markets started to speculate that John Taylor would join the Fed. Since he had invented the so-called Taylor rule, gold investors began to worry about a possible hawkish shift in the U.S. central bank. The reason is that the most common version of the Taylor rule implied much higher interest rates in 2017.

However, there are various rules – by changing parameters and altering variables, we can generate distinct prescriptions for monetary policy. It means that the introduction of the Taylor rule would not have to necessarily lead to a more hawkish monetary policy of the Fed, so the impact on the gold market would not have to be negative. And the rule-based approach would not necessarily increase the predictability of the Fed’s policy, at the central bank would have to choose the appropriate parameters and the appropriate version of the rule. It is similar to the case of gold investors whose idea for gold investment is to follow a rule – they are still responsible for making sure these rules work in their favor.

Last but not least, even if Taylor joins the Fed, his imprint on the U.S. central bank would be more dovish than expected, as he would have to persuade the rest of the FOMC to abide by the prescriptions of his original rule, according to which interest rates should be much higher. It would not be easy, so the impact of Taylor on the gold market would be probably less bearish than it is expected by many analysts.