An economic rule that outlines a method to set interest rates. The rule is named for John B. Taylor, an economist who was named by President George W. Bush to be an under secretary for international affairs in the U.S. Treasury Department. Previously, Taylor was an economist at Stanford University.
Taylor designed the rule in 1993 after observing how the Federal Reserve Open Market Committee actually set interest rates. Taylor’s rule aims to provide guidelines for a central bank, such as the Federal Reserve, to set short-term interest rates during changing economic conditions in order to achieve both short-term goals for stabilizing the economy and the long-term goal of managing inflation. According to Taylor, the real short-term interest rate, which is the interest rate adjusted for inflation, should be determined by three factors: where actual inflation is relative to the targeted level that the Federal Reserve wishes to achieve; how far economic activity is above or below its full-employment level; and the short-term interest rate consistent with full employment. Taylor deduced his rule in 1993. If inflation is above its target, or if employment is above full employment and interest rates are relatively low, rela-tively high interest rates are justified. However, if the goals are in conflict, such as when the economy is below full employment and inflation is above its target, the rule provides guidance to policy makers on balancing the competing considerations.