The Taylor Rule is a formula that puts Fed interest rate decisions on autopilot : The Indicator from Planet Money Today the Fed raised interest rates to just under 4%. The Taylor Rule says this should have happened a year ago. We talk to John Taylor about letting a formula do the work instead.

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John Taylor's formula for the Fed

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Today, the 12 members of what's known as the Federal Open Market Committee, or the FOMC, made a big decision.


JEROME POWELL: Good afternoon. My colleagues and I are strongly committed...


Fed Chair Jerome Powell announced the FOMC had decided to raise interest rates three-quarters of a percentage point today. And interest rates can be suffocating for a lot of people. Mortgages are more expensive. Car loans and credit cards get harder to pay off. Businesses stop hiring. The overall effect is designed to slow down the economy to tackle inflation.

WOODS: And instead of debating whether the 12 members of the FOMC are making the right or the wrong decisions, there's another way we could be reimagining the Fed's work altogether. We could be putting interest rates on autopilot with a basic formula that a high schooler could memorize.

JOHN TAYLOR: The guide is pretty simple. When they followed it, it's worked pretty well. When they haven't followed it, it's not worked so well.

WOODS: Stanford economist John Taylor is talking about his creation, the Taylor Rule.



CHILDS: And I'm Mary Childs.

The Taylor Rule is a disarmingly simple equation that could tell central banks how much to raise or lower interest rates. But recently, the Fed has strayed from this rule. Today's show - what it is and whether or not it could be better than expert human judgment.


WOODS: 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.

CHILDS: Even more fundamentally, it was unclear how a central bank should do central bank things. Like, the Fed's dual mandate - the core goal of keeping both prices stable and employment high - that didn't even exist until 1977. In the '70s, everything was up for debate. John Taylor was an economist then, recently out of his Ph.D. He was working at the Council of Economic Advisers under President Ford.

TAYLOR: There were all sorts of chaos in the '70s. 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. In other words, he was looking for a recipe for a soup that wouldn't be too salty or too sweet.

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 - exchange rates, government deficits, maybe the number of ships lining up at the ports. 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, not just the sophisticated people who know about all the ingredients and the taste.

WOODS: So John would take out one ingredient at a time and see how the model held up in keeping a hypothetical economy satiated. He'd maybe see if he could replace two variables with one, like - I don't know - instead of both consumption and investment, he could replace these with GDP, which covers the whole economy.

CHILDS: He was boiling it down. Meanwhile, at the Fed under chair Paul Volcker, central banking got more clarity. Yes, it had its dual mandate to keep prices stable and jobs plentiful. But in reality, it was focusing much more on the keeping-prices-stable part of its mandate - keeping inflation low.

WOODS: But John still felt like the Fed could be much clearer about how it went about its business. And in 1992, John was asked to give a talk at Carnegie Mellon University on what he'd been cooking over all these years. And the recipe was essentially this - raise interest rates by more than the spike in inflation. So we have this inflation target for the Fed. That's 2%. So let's say you have inflation bumbling along at 2%, but then, one day, it spikes up to 3%. Then, the Taylor Rule says that you would raise interest rates by 1 1/2 percentage points. That's more than that one-percentage-point bump in inflation that we've just had. And you'd 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. It was like, hey, let's try this. But it caught on quite quickly, and it worked pretty well. That's all.

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. These were times described as the great moderation - when inflation was low and any recessions were mild.

WOODS: And when the Fed had deviated from the Taylor Rule - where it hadn't raised interest rates as much as the rule suggested - 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. Here's John testifying in 2014 at the House Financial Services Committee.


TAYLOR: It is because of the success of policy rules that I recommend that legislation be put in place to require the Fed to report on its policy rule.

WOODS: And for the next four years, there were efforts in Congress to pass bills that would encourage the Fed to follow a rule like the Taylor Rule. One bill required the Fed to get audited for an explanation if they deviated. But the proposed bills faced strong resistance, notably from Janet Yellen, chair of the Fed at the time. She thought this breached Fed independence.


JANET YELLEN: I am very opposed and have - on the record as saying I am very opposed to...

WOODS: Janet Yellen is speaking at Stanford University in 2017, and John Taylor's in the room. And at first, Janet Yellen is complimentary.


YELLEN: Consider first the well-known Taylor Rule, which embodies key principles of good monetary policy.

CHILDS: But you know what happens with a compliment sandwich, right?

WOODS: Yeah.

CHILDS: The painful stuff is in the middle.

WOODS: Exactly.

CHILDS: It's not delicious. Janet Yellen points out that, yes, the formula is simple - just plug in inflation and where we are relative to potential GDP. But which indicators you use for those matter a lot. Like, do we use the consumer price index for inflation? Or do we use the Fed's preferred consumption expenditures index?

WOODS: Also, Janet Yellen says that geopolitical events, like trade wars, might be on the horizon - things that only a committee of human beings might be able to anticipate.

CHILDS: Janet Yellen also gave evidence that the Taylor Rule just systematically gives you interest rates that are too high. It doesn't take into account how shifts in globalization and demographics have pushed interest rates down overall in the last few decades.


YELLEN: The Taylor Rule, for this reason, provides a problematic benchmark.

WOODS: The speech was a passionate defense of human beings versus the robotic formula of the Taylor Rule. And the bill didn't pass, but the Fed did, on its own initiative, start publishing charts twice a year that showed what it had been doing with interest rates and compared that 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. Instead, they stayed near zero.

TAYLOR: I'd say, right now, that most central banks are still behind. I mean, 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.

TAYLOR: And what you have to say - well, look, this worked pretty well. It looks like it'll work in the future. Let's just do this. And my hope is this experience will bring us more in that direction rather than take us away.


WOODS: Taylor's vision 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.

WOODS: (Laughter) Wow.


WOODS: This show was produced by Brittany Cronin, with engineering by Maggie Luthar. It was fact-checked by Dylan Sloan. Viet Le is our senior producer, and Kate Concannon edits the show. THE INDICATOR is a production of NPR.


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