How this instrument works
John Taylor described this rule in a 1993 paper after noticing that the Federal Reserve's actual interest-rate decisions across the late 1980s tracked a strikingly simple formula: start from a neutral real rate, add current inflation, then adjust for how far inflation sits from its target and how far output sits from its potential. The formula was never adopted as binding policy — Taylor offered it as a benchmark against which any rate decision could be measured, not a rule any committee is obligated to follow.
The arithmetic hides one deliberate design choice worth naming: inflation appears twice. It is added once directly, at full weight, and then again inside the 0.5(π − π*) term whenever it strays from target. The combined weight on inflation above target works out to 1.5, not 1.0 — enough that the nominal target rate rises by more than inflation itself, so the real policy rate (nominal minus inflation) rises too. Economists call this the Taylor principle: a central bank that raises rates only as fast as prices are rising is not tightening policy in real terms at all, and can let an inflationary spiral feed itself.
Financial journalists and bond-desk strategists reach for this formula whenever a policy meeting approaches, comparing whatever rate was just announced against what the simple rule implies and reporting the gap as evidence policy is running loose or tight. The comparison is useful precisely because it is crude: the neutral real rate, r*, is not observed anywhere, only estimated — one widely cited running series from the Federal Reserve Bank of New York has drifted from above 2% before the 2008 crisis to under 1% in the years since, and swapping in a different r* estimate can move the prescribed rate by a full percentage point without any other input changing.
- Enter Neutral real interest rate, % — your assumption for r*, the real rate consistent with stable prices and output sitting at potential.
- Enter Current inflation rate, % and Inflation target, % — the actual reading and the central bank's stated goal, commonly 2%.
- Enter Output gap, % — how far actual output sits above (positive) or below (negative) potential output, as a percentage.
- Read Taylor-rule target interest rate, % — the nominal policy rate this benchmark formula prescribes from those four inputs.
- Change Current inflation rate, % on its own and watch Taylor-rule target interest rate, % move by one and a half times as much — the rule's built-in overreaction to inflation above target.
Worked example — the 6% reading from a hot economy
Set Neutral real interest rate, % to 2, Current inflation rate, % to 3, Inflation target, % to 2, and Output gap, % to 1 — a stand-in for an economy where prices are running a point above target and output is a point above potential. The formula starts with the 2% neutral rate, adds the 3% inflation reading outright, then layers on 0.5 × (3 − 2) = 0.5 for the inflation gap and 0.5 × 1 = 0.5 for the output gap. Summed together, 2 + 3 + 0.5 + 0.5 returns a Taylor-rule target interest rate, % of exactly 6.0.
Six percent nominal against 3% actual inflation implies a real policy rate near 3% — well above the 2% neutral real rate entered, and that gap is the rule's intended message: with inflation above target and the economy running hot rather than slack, a real rate left below neutral would let both conditions compound, so the formula pushes the prescribed nominal rate up by one and a half times the size of the inflation overshoot plus half the size of the output overshoot.
Questions
Is a central bank required to set rates exactly where this formula says?
No. John Taylor offered the formula in 1993 as a simple benchmark for judging policy, not a rule any monetary authority is bound to follow. Committees weigh financial stability, credit conditions, and forecasts the formula ignores entirely, so a reading from this instrument is a reference point for comparison, not a prescription.
Where does the Neutral real interest rate, % figure actually come from?
It is not observed directly — it is estimated. Researchers, including a widely cited running series from the Federal Reserve Bank of New York, model the real rate consistent with output at potential and stable inflation, and that estimate has moved substantially over time, from above 2% before 2008 to under 1% in the years since. Changing this one input by half a point moves the target rate by the same half point.
Why is the inflation gap multiplied by 0.5 instead of matched one-for-one?
Inflation already enters the formula once at full weight, added directly as the current reading. The extra 0.5(π − π*) term on top brings the combined reaction to inflation above target to 1.5, not 1.0 — enough that the nominal rate rises faster than inflation itself, so the real rate rises too. Without that extra half, matching inflation one-for-one would leave real rates flat and do nothing to cool an overheating economy.
How is Output gap, % here different from a GDP figure measured in dollars?
This field takes the output gap already expressed as a percentage of potential output, not the raw dollar difference between actual and potential GDP some other tools compute. A $500 billion gap against a $21 trillion economy is roughly a 2.4% output gap — convert a dollar figure to a percentage of potential output before entering it here.
Should I enter headline inflation or a core measure like core PCE?
Either is defensible, and it is the single choice most likely to change the result. The stated 2% inflation target many central banks use is commonly defined against a core price index, so a reading built on that series can differ noticeably from one built on headline CPI during energy or food price swings. Whichever series is chosen, keep Inflation target, % consistent with it.
References
Read this first: This instrument shows arithmetic, not advice. Real offers add fees, taxes and terms that vary by lender and place — verify the figures against your actual paperwork before deciding anything.