The Taylor Rule and its relevance to New Zealand monetary policy

The Taylor rule is a simple formula devised to mimic the United States Federal Reserve's interest rate decisions and is thought to perform well in the United States. It is based on relationships between the output gap, neutral real interest rates and the extent to which actual inflation has departed from the desired inflation rate. This article discusses some strengths and weaknesses of the Taylor rule, and then puts it into the New Zealand context. To the extent that it is appropriate for New Zealand, the Taylor rule might provide a useful input into the monetary policy decision-making process at the Reserve Bank. We compare New Zealand's short-term interest rate path with that suggested by the Taylor rule, and discuss how the Bank can use the Taylor rule as part of its framework for thinking about interest rate decisions.