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Monetary politics, inflation and unemployment: the Taylor rule

Posted on 05-Jul-2011

During the 2008 financial crisis, the ECB (among other central banks) reduced key rates at a historically-low rate to face the economic and financial turmoil. In April 2011, the ECB announced a 25 basis points rise of the key rate (to 1.25%), while the FED kept its key rate at its floor level (0.25%). How can we explain this difference?

John B. Taylor [1] suggests the following modelization of the key rate in his book “Macroeconomic Policy in a Word Economy: from econometric design to practical operation” [2]. A simple version of the Taylor rule defines the target rate as a function of the inflation rate and the unemployment gap:

Target rate = 1% + 1.5*Inflation – 1*Unemployment gap

where the unemployment gap is the difference between the current unemployment rate and the NAIRU (see glossary).

The objective of theTaylor rule is twofold:
- Follow the rise in inflation to keep it under control
- Promote investment and growth when the unemployment rate deviates from its natural rate

To analyze recent ECB and US interest rate movements, Fernanda Nechio [3]applies the Taylor rule described above to the euro area and to the Federal reserve, and compares the recommended target rate with the actual policy rate:

Since the 2008 crisis, the unemployment gap in the US rised to such a level that the target rate implied by the Taylor rule was negative (as illustrated in the bottom figure)! The conventional monetary policy became ineffective, which is why the FED set the rate to its lowest level (0.25%) and used a less conventional tool to stimulate the national economy: Quantitative Easing [4].

In Europe, the difficulty lies in the definition of a common monetary policy for countries experiencing very different macroeconomic conditions (measured by the unemployment gap, inflation and GDP in the chart below).

There is still a long way to go for European countries to continue their cultural and political integration effort in order to homogenize and strengthen the economic euro zone.

[1] John Taylor is a Professor of Economics at Stanford University, a member of the Hoover Institution, and the former Under Secretary of the Treasury for International Affairs under Bush’s administration.

[2] 1993 – New York: W. W. Norton Company

[3] Source: Fernanda Nechio, "Monetary Policy: When One Size Does Not Fit All", FRBSF Economic Letter, June 13, 2011. http://www.frbsf.org/publications/economics/letter/2011/el2011-18.pdf

[4] Quantitative easing (QE) is an unconventional monetary policy tool used by some central banks to stimulate the national economy when conventional monetary policy has become ineffective. A central bank implements quantitative easing by purchasing financial assets from banks and other private sector businesses with new money that it creates electronically.