The Taylor Rule Applied to Australia

Key takeaways

• The rule prescribes a rate from inflation and the output gap.
• Its inputs - neutral rate, output gap - are estimated, not observed.
• Small changes in assumptions produce large changes in the prescribed rate.
• Useful as a cross-check on policy, useless as a forecast.

What is the rule?

In its standard form, the prescribed nominal policy rate equals the neutral real rate, plus current inflation, plus a weight on the deviation of inflation from target, plus a weight on the output gap.

Conventionally both weights are set at 0.5, though that is a convention rather than a discovery. The intuition is simple and appealing: when inflation is above target, raise rates by more than the excess so the real rate rises; when output is below potential, ease.

The insistence that the response to inflation be greater than one-for-one is the important part - the Taylor principle. If the nominal rate rises by less than inflation, the real rate falls, and policy loosens exactly when it should tighten.

Why does it not tell you what the RBA will do?

Because almost every input is contested.

Change the neutral rate assumption by half a percentage point and the prescribed rate moves by half a point. Change the output gap estimate by a percentage point and it moves by another quarter. Two competent economists can apply the same rule to the same economy and differ by more than a percentage point.

The RBA also has a dual mandate covering price stability and full employment, and considers financial stability and the exchange rate. A single equation cannot represent that, which is why no central bank follows a Taylor rule mechanically.

What is it actually good for?

Three genuine uses.

• A sanity check. If policy is far from every reasonable Taylor prescription, that is worth explaining - and central banks are often asked to explain it.
• Communication. It gives a shared vocabulary for discussing whether policy is tight or loose relative to conditions.
• Historical analysis. Applied after the fact, when the data has been revised, it is a reasonable way to characterise past policy episodes.

What it is not good for is predicting the next decision. For a borrower, the takeaway is the same one that applies to every model in this area: use it to understand the mechanism, not to time a fixed-rate decision.

Frequently asked questions

What is the Taylor rule?

A formula prescribing a policy interest rate based on the neutral real rate, current inflation, the deviation of inflation from target, and the output gap. It was proposed as a description of good policy rather than a mechanical rule.

Does the RBA use the Taylor rule?

Not mechanically. The RBA considers a wide range of information and models, and has a mandate covering both price stability and full employment. Taylor-type rules are used as one benchmark among many.

What is the Taylor principle?

The requirement that the nominal policy rate respond more than one-for-one to inflation. If it does not, the real interest rate falls as inflation rises, loosening policy exactly when it should tighten.

Why do different economists get different Taylor rule answers?

Because the key inputs - the neutral real rate and the output gap - are unobservable and must be estimated, and the response weights are conventional. Small differences in assumptions produce large differences in the prescribed rate.

Related reading

• How the RBA Actually Sets the Cash Rate: The Reaction Function
• The Neutral Rate (r*): Why Estimates Disagree
• NAIRU: Why Unemployment Drives Your Mortgage

Sources

• Statement on Monetary Policy — Reserve Bank of Australia
• Research on monetary policy rules — Reserve Bank of Australia