Taylor Rule And Gold

In the November edition of the Market Overview, we briefly discussed a Taylor rule, showing that adopting it would lead to significantly higher interest rates. But how goes that rule really work? It is worth analyzing it, as John Taylor, although not chosen as the next Fed Chair, may be still nominated into the Board of Governors and advocate for a more rule-based approach.

The Taylor rule can be expressed in the following equation:

R_fed = R_real + Inf + 0.5 * (Inf – Inf_target) + 0.5 * (GDP_real – GDP_potential)

R_fed is the interest rate set by the central bank. R_real is the assumed equilibrium real interest rate, Inf is the rate of inflation, Inf_target is the target inflation rate, GDP_real is real GDP, and GDP_potential is potential GDP, i.e. GDP corresponding with full employment. The result of subtraction of these two variables is called the output gap (expressed as y), which is the difference between the real and potential output. The formula may seem complicated, but assuming both a target rate of inflation and equilibrium of the real interest rate at 2 percent, we get a simplified form of the equation:

R_fed = 1.5 * Inf + 0.5 * y + 1

Thus, the Taylor rule is actually a simple recipe for interest-rate policy. When the economy is at full employment and price inflation is at the 2-percent target, then the central bank should set the interest rate at 4 percent. If the inflation rate increases (decreases) by 1 percentage point more, the central bank should raise (cut) the interest rates disproportionately by 1.5 percentage point to 5 percent (3 percent). If unemployment rises and the output gap falls to -1 percent, the central bank should lower the interest rate to 3.5 percent. As one can see, the central bank should be more worried about inflation than about the output gap (but it depends on the parameters used).

Although the formula is simple, the devil is in the details. First of all, the equation does not take into account other factors than inflation and output gap, such as the financial conditions (asset prices or the level of indebtedness, and so on). Hence, following the rule could make central bankers to neglect the risk of financial imbalances. If such risks materialize, gold – as a safe-haven asset – should shine.