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How reliable is the Taylor rule as a policy setting tool?

John Taylor, the Stanford university economist, is currently making headlines, as he is on President Trump’s short list to lead the Federal Reserve. Taylor is mostly recognized for the monetary policy rule he introduced back in 1993 that is intended to both prescribe and describe the Federal Funds Rate, the short-term interest rate targeted by the Federal Open Market Committee (FOMC). Taylor has argued that his rule should also be used for policy setting purposes, and, more specifically, should act as a benchmark for monetary policy decision making. More importantly,  there is widespread belief that a Taylor-led Federal Reserve would adopt or lead to a more hawkish monetary policy stance. If that were to happen, it would be a significant deviation from the current and expected path of U.S. monetary policy and would have significant implications for asset markets.

The report argues that, although the Taylor rule is a valuable, straightforward and rational tool or guideline, it might not integrate all necessary parameters for taking policy decisions in a complex and constantly changing economic environment. In addition, the fact that changing the inputs and assumptions of the model, can lead to a rather diverse set of outcomes, reveals the shortcomings of a ‘mechanical’ rule. The focus is to elaborate on the mechanical nature of the rule, and the implications for policy setting.

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Iniohos Advisory Services

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