Clarifying Some Key Taylor Rule Calculations

Justin Lahart has an article in the Wall Street Journal today about the Taylor Rule and the time inconsistency of the Fed’s forward guidance. I agree with the spirit of the piece, but unfortunately the article misquotes the Taylor rule which has caused some confusion.

Justin writes that “John Taylor’s original framework says that the target [federal funds] rate should be 1.5 times the inflation rate plus .5 times the output gap.” However, as I wrote on this blog in 2010 and in many other places over the years, “The Taylor rule says that the federal funds rate should equal 1.5 times the inflation rate plus .5 times the GDP gap plus 1.” So Justin omitted the “plus 1.”   The “plus 1” is very important. It means that the target inflation rate is 2%, which is what I recommended 20 years ago and is now what the major central banks use.  You can see this by noting the equivalence of the two equations on the slide below which I use in my Economics 1 course at Stanford. (If you omit the “plus 1” you are implicitly assuming the target inflation is 4%).  In 1992 I wrote the equation in red oval, which is the same as the one in the blue oval

TR slide

It is interesting that Jutin gets the right answer for the funds rate even though he misquotes the rule: If you plug in Justin’s inflation rate (1.2%) and gap (3%) into his statement of the Taylor rule, you get 0.3 %. But he says he got 1.3%.  So he must not have omitted the “plus 1” when he did the math even though he omitted it in the article.

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