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What is the Taylor Rule?

The Taylor Rule is founded on the insight that U.S. federal monetary policy is largely an effort to keep inflation and growth in economic output close to levels that are regarded as acceptable. It starts with a real funds rate of 2%, not adjusted for inflation. This represents a neutral monetary policy that neither boosts nor impedes growth. The current inflation rate is added and the result is adjusted by factoring in the difference between acceptable inflation, assumed to be 2% and the actual rate, along with the GDP gap.

The GDP gap is the difference between the actual and the potential gross domestic product. Potential GDP is defined as the maximum growth that can be achieved in a year without causing an acceleration in inflation. Analysts use the Taylor Rule as a method of deducing imminent modifications to the current Federal Reserve funds rate from the most recent economic numbers. Such predictions are always tentative, as the Taylor Rule is not a precise tool.