When Not to Follow Taylor-Type Rules

Abstract

Since the 1970s, monetary policymakers have available feedback rules to help guide decisions. One of the most famous and widely followed rules is that of John Taylor. The usual Taylor-type rule representation has the central bank policy nominal interest rate determined by the natural real rate and the inflation rate along with feedback from the output gap and the inflation rate gap. This rule is so widely respected that policymakers and researchers investigate rule updates and modifications to demonstrate how actual policy can be considered as consistent with these modernized Taylor-type rules. This study, instead, provides conditions under which policy can be improved by purposely not following what Taylor-type rules prescribe. An implication is policy should not always be regarded as optimal or even beneficial simply because it is consistent with Taylor-type rules. A new rule is introduced, which is not a Taylor-type rule, that can reduce the severity of, or possibly eliminate, recessions that arise from high and rising inflation rates. With the new rule, the Taylor principle outcome, where the policy real rate moves in the same direction as the inflation rate, is conditional upon past inflation rates and their rate of change. If these past inflation rates are ignored, as with Taylor-type rules, the result will be higher unemployment rates and severer recessions compared to when the new rule is followed.