Where Should the Fed Set Rates? Ask Taylor

If you ask President Trump where interest rates should be, he'll likely say much lower. Some Federal Reserve policymakers, including Chairman Jerome Powell, disagree and paused rates in a January vote that wasn't close and indicated little likelihood of another cut until mid-year or later.

As debate swirls, investors might find themselves on one side or another, wondering if there's an objective way to decide a so-called "neutral" rate that neither over- nor under-stimulates the economy.

In fact, there is a mathematical formula called the Taylor rule that was developed to answer that question and give policymakers and economists a rough guide of where rates should move based on current economic conditions.

While the formula may seem complicated for the mathematically challenged, the basis is simple enough and can provide investors a sense of where the neutral rate might be. While rates don't always take a linear path toward neutral, they generally move that direction over time. Knowing objectively where that level is can help investors determine if rates are too high or low and use it as one tool for their portfolio analysis.

The Taylor rule is an equation John Taylor, a Stanford University economist, developed in 1993 to provide recommendations for how a central bank like the Fed should set short-term interest rates as economic conditions change.

According to the San Francisco Fed, the Taylor rule states that the "real" short-term interest rate adjusted for inflation should be determined using the following three factors:

• Where actual inflation is relative to the targeted level the Fed wishes to achieve.
• How far economic activity is above or below its "full employment" level.
• The level of short-term interest rates that would be consistent with full employment.

The rule recommends a relatively high interest rate, or tight monetary policy, when inflation is above its target or when the economy is above its full employment level, and a relatively low interest rate, or easing monetary policy, is in the opposite situation.

To dive deeper into how the rule works, investors can check the Atlanta Fed's website—an interactive site where they can plug in their own estimates of inflation and unemployment and come up with an appropriate rate.

Over the 33 years since the rule debuted, there've been various modifications allowing different data to be plugged in to calculate a rate, meaning analysts can generate many different "Taylor rules." Because of the complexity, some economists consider Taylor more of a guidepost than ironclad.

"I look at the various Taylor rules as one input, partly because I know the Fed looks at it and because it's one of the few tools we have that generates a fair value for the fed funds rate," said Kathy Jones, chief fixed income strategist at the Schwab Center for Financial Research. "I look at it to say, 'How far is the actual rate from the one that the Taylor Rule indicates?'"

In a 2018 speech, Fed Chairman Powell said using the Taylor rule is the economic equivalent of using the stars to navigate or guide you.

"Navigating by the stars can sound straightforward," Powell said. "Guiding policy by the stars in practice, however, has been quite challenging of late because our best assessments of the location of the stars have been changing significantly."

Changes he cited were projections of the natural rate of unemployment and the potential growth rate of gross domestic product (GDP). Both can differ depending on an observer's theories and observations.

In the debate between Powell—whose chairmanship ends in May—and Trump, the Taylor formula suggests Powell is closer to correct. Based on current levels of inflation and GDP growth, the fed funds range of 3.5% to 3.75% is far from restrictive. In fact, current levels—down from above 5% as recently as mid-2024—may be too loose and threaten to unleash more inflation.

"What stands out to me now is that the current fed funds rate is below nearly every Taylor rule projection, which suggests no need for the Fed to cut rates," Jones said. "All Taylor rule models would indicate that the fed funds rate should be higher—no matter how they are modified."

Current Taylor rules, as of mid-February, project the fed funds futures target should be in the 4% to 5.5% range, depending on which metrics one plugs into the formula.

The logic for a rate cut "just isn't there right now," Jones added. "Inflation is stuck closer to 3% than 2%. The economy is growing at probably a run rate of 3.5% to 4% in terms of GDP. Fiscal stimulus is coming due to the One, Big, Beautiful Bill. And we have a lot of momentum in the economy."

The rate debate played out in Powell's late-January press conference. The Fed's latest Summary of Economic Projections (SEP), projecting where policymakers expect rates to go, showed just three members expect rates, over the long run, will be above the current fed funds target range. A large majority believes a neutral rate would be below current levels, though some see current levels as neutral.

That arguably puts Powell in the minority on the Fed, though he pushed for his view when asked about the SEP.

"I think, and many of my colleagues think, it's hard to look at the incoming data and say that policy's significantly restrictive at this time," Powell replied. "It may be sort of loosely neutral, or it may be somewhat restrictive. It's in the eye of the beholder, of course, and no one knows with any precision."

With that in mind, Schwab's Jones sees the Taylor rule as a useful tool but not the only one when trying to understand the rate path. "At the end of the day, we look at the economic data, try to read what it tells us about the future trends, and then look at what markets are expecting," Jones said. "If they all line up—that's great. But lately, they generate different readings, so we are left to our own judgement. The Taylor rules are just one input."

Investors who understand the Taylor rule could consider it along with many other factors in shaping their portfolios. For instance, an investor who uses the Taylor rule decides that the Fed's target rate is well above the neutral line might determine the Fed could cut rates two to three times this year. This would likely give stocks a tailwind, helping equities, and the investor could adjust their portfolio by going longer in stocks.

On the other hand, if an investor—using the Taylor rule—finds they agree with Powell that rates are close to neutral now and that few, if any, cuts are needed, they might take a more bearish approach to stocks.

Kevin Warsh, Trump's nominee to replace Powell as Fed chairman, has his own thoughts on Taylor. Back in 2008 as a governor at the Fed, he argued that the rule, while useful, has limitations.

"By design…the Taylor rule focuses largely on what can be observed in real time, without accounting for some factors that influence monetary policy," Warsh said in a speech. "For example, policymakers may try to peer, however imperfectly, into the future when setting the federal funds rate rather than responding solely to the current state of the economy. Some central bankers find this more forward-looking approach to be particularly appealing when financial market prices and other high-frequency indicators suggest that the economy is poised to change direction markedly."

In a Wall Street Journal opinion piece late last year, Warsh offered more insight along the same lines, and investors might want to take note. He stuck with his belief in a more forward-looking approach that would potentially give older ideas like the Taylor rule less credence. He thinks the Fed needs to take into account possible disinflation triggered by the AI revolution, which would potentially allow the Fed to keep rates far lower without sparking inflation.

"The world is moving faster, yet the Fed's leaders are moving slower," Warsh wrote. "They appear stuck in what Milton Friedman called 'the tyranny of the status quo.' The Fed should discard its forecast of stagflation in the next couple of years, as if subpar growth and inflation 40% above target is the best that can be done. AI will be a significant disinflationary force, increasing productivity and bolstering American competitiveness."

"We can lower interest rates a lot," Warsh told Fox Business last year.