Using the Taylor Rule to Forecast the Federal Funds Rate

The Taylor rule is a formula devised by Stanford economist John Taylor. The formula was designed to provide a central bank with a guideline for determining the appropriate rate to set short-term interest rates.  The formula is:

r = p + 1/2(y) + 1/2(p-2) + 2

Where r is the federal funds rate, p is the inflation rate, and y is the GDP gap, which is the difference between actual and potential output. The 2 at the end is the historically neutral real federal funds rate. The formula assumes 2% is the targeted inflation rate. 


The federal funds rate is increased or decreased based on two variables: inflation and real GDP.  If real GDP rises 1 percent above potential GDP, then the federal funds rate should increase 1/2 percent. If inflation rises by 1 percent above its target of 2 percent, then the federal funds rate should increase by 1/2 percent. If the inflation rate is 2% and real GDP is equal to potential GDP, then the federal funds rate should be set to 4%. Research has shown the Taylor Rule does a reasonable job of estimating the federal funds rate (see chart here). Although, there have been a few attempts to modify the Taylor Rule of late. See  Bloomberg: Taylor Rule Change Will Hurt Fed's Inflation Fight, Glenn Rudebusch FRBSF Economic Letter , and John Hussman "Taylor" Your Fed Expectations for more on the Taylor Rule.
  
To solve for the current federal funds rate, one first determines the output gap. Current (2017 Q3) Real Potential Gross Domestic Product is $17,125.50 and the Real Gross Domestic Product is $17,169.73. The output gap is $44.23 or 0.2583% above potential. The inflation rate is 1.8% according to the latest year over year GDP implicit price deflator. The calculation results in a 3.83% federal funds rate.

The various forms of the Taylor Rule are provided by the Atlanta Fed's Taylor Rule Utility. The results for Q3 2017 are:

The Cleveland Fed Simple Monetary Rules page also calculates seven federal funds rates from various monetary policy rules, one of which is the 1993 version of the Taylor Rule.

The CME Fedwatch Tool can also be used to see what the market predicts the Fed will do at future meetings. There is currently about a 50/50 chance the Fed increases interest rates by 0.25% at the March 21, 2018 meeting.