The third element in the Taylor rule calls for an adjustment of the funds rate to departures of real GDP from some measure of “potential” GDP. Simply put, when GDP is below “potential,” the funds rate should be reduced, and when it is above, it should increase. I will point out that our recent thresholds did not provide a reaction function.
They simply suggested a range of economic conditions under which we would not act. They conveyed nothing about our actions in other states of the economy. In my view, this was one of the major drawbacks to the approach and the reason changes were needed. Over the past 20 years, the Taylor rule has garnered a great deal of attention and study.