The famous interest rate rule has turned toward a drop in interest rates

The stock market is already pricing clear policy rate cuts for next year. The famous Taylor interest rate rule is in its own interest rate reading, but like market expectations, it has also taken a turn toward falling central bank rates.

Source: Bloomberg

In Eurozone and Sweden, interest rate estimates go nearly hand in hand and are now slightly below 10%. In the United States, the estimate is, actually slightly surprisingly, clearly lower, probably due to inflation dynamics. As the figure shows, the policy rate would still be significantly higher than the COVID pandemic levels, but the direction is also the same here.

What is the Taylor rule?

The Taylor rule is a widely known monetary policy targeting rule in academic debate. It simply describes what would be the optimal policy rate for each economic situation when the variables are inflation and economic activity. Rule-based monetary policy is known to be a positive thing, as it brings consistency and efficiency to central bank decision-making. The Taylor rule ‘writes in’ the policy objectives of central banks (price stability at the ECB, price stability and employment targets at the Fed) and calculates the optimal interest rate level in each economic environment based on these.

The rule developed by John Taylor in 1993 is widely known for its easy approach, and I myself have calculated interest rates in economics courses using the rule. Simplicity is also the biggest stumbling block of the rule, as central banks' monetary policy must consider other factors in addition to the ones included in the monetary policy rule. For example, in addition to the current situation, attention is also paid to the future (importance of forecasts) and, e.g., financial stability, and the Taylor rule has been modified to be based on forecasts. In addition to a rule-based monetary policy, decision-making can and does have elements based on judgment. Central banks' reaction functions, i.e. the weight given, for example, to price stability in monetary policy may also change over time. For example, the COVID crisis increased the need for a means-tested monetary policy and quick action. The rule does not consider the effectiveness of monetary policy either, i.e., the power with which already taken actions are transmitted to the economy.

Is the Taylor rule correct?

Due to the above-mentioned factors and simplicity, the Taylor rule does not tell the whole truth about optimal monetary policy. For three decades it has, however, been an important part of monetary policy research and the toolbox of many central banks. Central banks were criticized for the lag in responding to high inflation, and the Taylor rule supports these ideas, as well as the idea that a zero-interest environment is not always the best option for an optimal outcome.