What Is “Taylor Rule”? What Does It Say Now? Was It A Factor In Bernanke’s Decision?

The Taylor Rule, proposed first by economist John Taylor in 1993, is a monetary policy formula (or rule) that stipulates how much the Federal Reserve Bank should change its federal funds rate in response to GDP (gross domestic product) and inflation. For example, if inflation were to rise by 1%, the proper Taylor Rule response would be for the Fed to increase interest rates by approx. 1.5% and if GDP falls by 1%, then the proper response would be to cut the interest rate by 0.5 %.

Although the Fed does not explicitly follow the rule, analysis shows that the Taylor Rule does do a fairly accurate job of describing how US monetary policy actually has been conducted during the past decade (for more details see http://en.wikipedia.org/wiki/Taylor_rule).

In December 2008, the Federal Reserve had already reduced its main interest rate to a range of 0% – 0.25%. In other words, the Fed had gone as far as it could in lowering its main interest rate. The US GDP fell by 6% in the fourth quarter of 2008 and inflation, despite the feverish imagination of some commentators, seems to be falling. So we thought the Taylor Rule should also suggest a near 0% interest rate.

And were we wrong? And how? We found out that, according to Goldman Sachs, the Taylor Rule was pointing to a (-8%) federal funds interest rate. They were not alone. According to Deutsche Bank’s calculation of the Taylor Rule, the federal funds rate should bottom at -7.3% by Q3 2009 and gradually rise to -3.5% by Q4 2010. 

What a concept? A negative interest rate of -7%. Or in other words, the Fed should be paying us an interest rate of 7% to lend us its money

No central bank would ever do that in practice. So the Taylor Rule is showing all of us how weak the American Economy is. It is so weak that it needs negative interest rates to get out of its funk.

Since the Fed cannot implement negative interest rates, what can it do? The only choice left is to bring down long maturity interest rates (2,5,10 year interest rates) by buying such securities in the open market, to bring down mortgage rates by buying mortgage securities in the open market and so on. 

Now you understand why Bernanke decided to not wait any longer and why he announced their planned purchase of about 1.1 trillion dollars of securities to expand the Fed’s balance sheet to $3 trillion.

When you hear TV talking heads discussing hyper inflation resulting from this Fed action, ask them to read what Goldman Sachs is saying. You are not going to believe this but, according to Goldman Sachs calculations, the Fed might need to expand its balance sheet by as much as $10 trillion to make Fed policy “appropriately easy”.

Are you sitting down? Fed needs to buy as much as $10 trillion of securities in the open market? Now that is just a quantitative calculation and not practical at this time. But you will now understand why Bill Gross said after the Fed decision on Wednesday “I still think that is not enough”.

It is easy to talk in thin air about hyper inflation and criticize Ben Bernanke for going overboard. The problem with Mathematical Rules is that they do not accept loose talk. Just calculations.

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