Tracking Monetary Policy Using the Output Gap, Inflation, and the Taylor RulePanel (a) shows that the federal funds rate usually rises when the output gap is positive—that is, when actual real GDP is above potential output—and falls when the output gap is negative. Panel (b) illustrates that the federal funds rate tends to be high when inflation is high and low when inflation is low. Panel (c) shows the Taylor rule in action. The green line shows the actual federal funds rate from 1985 to 2010. The purple line shows the interest rate the Fed should have set according to the Taylor rule. The fit isn’t perfect—in fact, for a period after 2009 the Taylor rule suggests a negative interest rate, an impossibility—but the Taylor rule does a better job of tracking U.S. monetary policy than either the output gap or the inflation rate alone.
Sources: Federal Reserve Bank of St. Louis; Bureau of Economic Analysis; Bureau of Labor Statistics.