What is the Taylor rule
The Taylor rule is a formula that suggests what a central bank's policy interest rate should be, based on how far inflation is from target and how far the economy's output is from its normal level.
It was proposed by economist John Taylor. It does not set any real policy rate. Central banks use it, along with many other inputs, as a reference point for policy decisions.
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Taylor rule formula
The general form is:
i = r* + π + a(π − π*) + b(y − y*)
| Symbol | Meaning |
|---|---|
| i | Suggested nominal policy rate |
| r* | Neutral real interest rate: the rate that neither speeds up nor slows down the economy |
| π | Current inflation |
| π* | The central bank's inflation target |
| y − y* | Output gap: actual output minus potential output, as a share of potential |
| a, b | Weights on the inflation gap and the output gap |
In Taylor's original version, the two weights were equal. Later versions give the output gap a larger weight or change the inflation measure.
The Taylor principle
The rule implies that when inflation rises, the policy rate should rise by more than the rise in inflation. The real interest rate, which is the nominal rate minus inflation, then goes up and cools demand. If a central bank raises its rate by less than inflation rises, real rates fall and policy becomes looser.
Worked example (hypothetical)
Take an imaginary economy where:
- inflation is above the target, so (π − π*) is positive;
- output is above potential, so (y − y*) is positive.
Step by step:
- Start with r* plus current inflation. This is the rate that keeps real rates neutral.
- Add the inflation gap times its weight. This term pushes the rate higher.
- Add the output gap times its weight. This term also pushes the rate higher.
Result: the rule suggests a policy rate above the neutral level. If inflation fell below target and output fell below potential, both gap terms would turn negative and the suggested rate would fall below neutral.
Where the term appears
- Central bank reports and speeches. Monetary policy statements and research papers often compare the actual policy rate with Taylor rule estimates.
- News and analyst notes. Commentators use the rule to argue that a central bank is "behind the curve" or "too tight". For example, a decision such as SBP policy rate raised by 50 bps to 12% with effect from 27.10.2026 (MPC) may be compared against rule-based estimates in market commentary.
- Fundamental analysis. Traders follow expected rate paths because interest rate differences affect currency pairs. See fundamental analysis and currency pairs.
Rate expectations can move prices quickly. Leveraged forex and CFD trading can lose money fast, including around central bank decisions.
Limits and edge cases
- Unobservable inputs. The neutral rate and potential output cannot be measured directly. Different estimates give different answers.
- Data revisions. Inflation and output figures are revised later, so the rule computed in real time can differ from the rule computed afterwards.
- Choice of inflation measure. Headline, core or expected inflation each give a different result.
- Zero lower bound. In a deep slump the formula can suggest a negative rate that a central bank may not set.
- Supply shocks. An oil or food price shock raises inflation while output falls; the two gap terms pull in opposite directions.
- Rate smoothing. "Inertial" versions include last period's rate, because central banks usually move in small steps measured in basis points.
- Open economies. In emerging markets, exchange rate moves feed into inflation, so some versions add an exchange rate term.
Related terms
Basis point · Disinflation · Deflation · Business cycle · Currency depreciation · Covered interest parity · Fiscal deficit · Trading glossary
Frequent questions
What is the Taylor rule in simple words?
It is a formula that suggests a policy interest rate from inflation versus target and output versus its normal level.
Do central banks follow the Taylor rule exactly?
No. They use it as one reference among many and also weigh financial stability, exchange rates and data quality.
Why does the Taylor rule matter to forex traders?
It helps explain market expectations about rate changes, which affect interest rate differences between currencies. It is not a forecast or a trading signal.
What is the output gap?
It is the difference between actual economic output and the estimated potential output, shown as a share of potential.