The second factor is a function of the deviation of inflation from the central bank’s target or goal. If inflation is above the target, the Taylor rule says the funds rate should be higher, and if it is below target, the funds rate should be lower.
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.