Taylor’s rule is a formula developed by Stanford economist John Taylor. It was designed to provide “recommendations” for how a central bank like the Federal Reserve should set short-term interest rates i.e. the “Policy rate” as economic conditions change to achieve both its short-run goal for stabilizing the economy and its long-run goal for inflation. Specifically, the rule states that the “real” short-term interest rate (that is, the interest rate adjusted for inflation) should be determined according to three factors:
(1) where actual inflation is relative to the targeted level that the Fed wishes to achieve,
(2) how far economic activity is above or below its “full employment” level, and
(3) what the level of the short-term interest rate is that would be consistent with full employment.
The rule “recommends” a relatively high interest rate (that is, a “tight” monetary policy) when inflation is above its target or when the economy is above its full employment level, and a relatively low interest rate (“easy” monetary policy) in the opposite situations. Sometimes these goals are in conflict: for example, inflation may be above its target when the economy is below full employment. In such situations, the rule provides guidance to policy makers on how to balance these competing considerations in setting an appropriate level for the interest rate.
Below an interesting graph by the BIS which compares the average (mean) interest (policy) rates to the average Taylor rate in Western economies.