Prior to his service at the U.S. Treasury from 2001 to 2005, John Taylor had two previous policy-making stints in Washington. Each time he has returned to academia to produce important research, and he credits the government service in part for the ideas. After serving on President Gerald Ford’s Council of Economic Advisers in the mid 1970s, he showed mathematically how the observed tendency for wage and price changes to be staggered over time could help explain inflation for the whole economy. Nearly 30 years later, in 2005, Donald Kohn, now vice-chairman of the Federal Reserve, said in a speech in Germany that Taylor’s “staggered contracts framework remains a touchstone” for modeling the impact of monetary policy on inflation.
His work in 1992 following his time on President George H.W. Bush’s economic team also became influential, and even better known in financial markets. It was a simple equation designed to provide the Federal Reserve with a guide for setting short-term interest rates. The equation r = p + .5y + .5(p - 2) + 2 uses the inflation rate over the previous four quarters (“p”) and the percentage that gross domestic product deviated from the Fed’s target (“y”) to calculate the federal funds rate (“r”).
The formula offered a useful tool for making policy moves effectively, and surprised many when it started “tracking” the interest rate in subsequent Fed decisions, and even in the decisions of other central banks around the world. It became known as the Taylor Rule.
In a speech before the National Economists Club in 2004, current Federal Reserve chairman Ben Bernanke—a former Stanford economics professor—said the Taylor Rule “instructs policy makers to ‘lean against the wind’; for example, when output is above its potential or inflation is above the target, the Taylor Rule implies that the federal funds rate should be set above its average level, which (all else being equal) should slow the economy and bring output or inflation back toward the desired range.”
He said the principle Taylor’s formula codifies “seems likely to be a feature of any good monetary policy and thus provides an important guidepost for policy makers.”