The Taylor Principle and Fed Policy

~ 200 words, ~1 min reading time

John Taylor is a macroeconomist from Stanford, mostly known for his “Taylor Rule” – a rule describing both historically how the Fed has targeted interest rates and how it *should* target interest rates.

He is also known for the related “Taylor Principle”, which is a little bit broader. The idea is simple: the central bank should increase interest rates at least as much as any increase in inflation. This is necessary for monetary policy to have a stabilizing influence. If the central bank follows this principle, an increase in inflation causes an increase in real (that is, inflation adjusted) interest rates, which will discourage spending – keeping inflation in check. If we don’t follow this principle, then inflation tends to spiral out of control, as inflation leads to decreasing inflation-adjusted interest rates, which encourages spending – driving inflation further up.

Since April 2020, price inflation has risen from almost nothing to about 8% on a year-over-year basis. Meanwhile, the Fed’s interest rate target has risen from 0-0.25% to 0.25%-0.5%. All to say: there’s a lot of room for interest rates to rise.

Leave a Reply

Your email address will not be published.