Should Interest Rates Be Higher? A Rules-Based Approach to Policy Says Yes.

The Federal Reserve’s decision to cut interest rates this fall diverged notably from what the Taylor Rule, a formula that ties inflation to growth, would have prescribed. (Michael M. Santiago/Getty Images)

Federal Reserve officials are publicly at odds ahead of the central bank’s December policy meeting about whether to cut interest rates again to bolster the labor market. But behind the latest controversy is a long-simmering and arguably more important debate about how to set monetary policy: on the basis of fixed rules, or central bank officials’ judgment.

A rules-based approach would put the federal-funds rate significantly higher than its current level, advocates say, while the current approach may leave the markets guessing until the Fed’s postmeeting statement is released on Dec. 10.

The Fed cut its benchmark federal-funds rate by a quarter of a percentage point in September, and again in October, leaving the current target range at 3.75%-4.00%. Both reductions were cast as “insurance” against further deterioration of the labor market and the economy, even though inflation is still about a percentage point above the Fed’s 2% annual target.

Proponents of a rules-based policy, as opposed to the current Fed’s data-dependent approach, say rates should be at least a third of a percentage point higher in view of the inflation backdrop. They say that lower rates heighten the risk of another surge in price growth, potentially mirroring the post-Covid surge just a few years ago.

For decades, economists and Fed staff have used mathematical models such as the Taylor Rule as guidelines for setting interest rates. Developed in the 1990s by Stanford University economist John Taylor, this decision-making framework links rates to inflation and growth and stipulates that rates should be raised when inflation exceeds an established target or the economy runs hotter than expected. While the Fed hasn’t followed this or other formulas mechanically, its policy decisions in recent months have diverged notably from what the Taylor Rule would prescribe.

That deviation has become harder to ignore with the most recent round of rate cuts, especially as a 43-day government shutdown this fall deprived policymakers of much of the data on which they depend to gauge the economy’s health. To critics, the Fed’s latest moves highlight the risks of data dependence, or a flexible, judgment-based approach that they say can leave the central bank unmoored when data are scarce or unclear.

Research from Allianz Trade estimates that the federal-funds rate now sits roughly half a percentage point to three-quarters of a point below the level implied by a standard Taylor-rule calculation. That is the widest gap since 2022, when the Fed underestimated inflation and saw prices rise to a 41-year high of 9.1%.

“The Fed followed this framework very closely for 25 years,” said Allianz economist Maxime Darmet of the Taylor Rule. “The last time the Fed deviated from this rule was in 2022 when inflation picked up very rapidly…this is not warranted.”

Darmet told Barron’s that with inflation above target and the economy stronger than the Fed’s projections suggested, policy is now more dovish than conditions call for.

The Fed did not comment. Critics of the rule say it doesn’t account for supply-chain disruptions and policy changes that have recently driven inflation higher.

A recent analysis by Eric Hickman, founder of Lantern Capital, a manager of interest rate futures, reached a similar conclusion. Lantern found that one rate cut in September would have kept policy roughly consistent with the Taylor rule, but that additional easing has pushed the Fed below prescription. “Absent a forecast of economic weakness or falling inflation, the fed-funds rate [was] ‘in a good place’ especially with inflation this high and rising,” Hickman wrote in a September note. “This contrasts with the Fed’s cuts at the end of last year when the Taylor Rule encouraged the Fed to lower the fed-funds rate the 1% that they did [in 2024].”

Hickman warned that further cuts risk reigniting inflation pressures that appeared to have cooled earlier in the year. Such concerns are finding a wider audience among hawkish Fed officials and non-Fed economists, who argue that policymakers should pause before easing further.

Powell himself acknowledged growing disagreement inside the Federal Open Market Committee. “A further reduction in the policy rate at the December meeting is not a foregone conclusion. Far from it,” he said after the October policy decision. “Policy is not on a preset course.”

Supporters of the Fed’s current approach counter that rigid formulas can’t capture an economy in flux, and central bank officials have said as much. On its website, the Fed notes that while it consults rules like the Taylor Rule, it “does not mechanically follow them.” Policymakers argue that key inputs to such rules are highly uncertain and constantly changing, making mechanical adherence risky. The Fed’s staff regularly presents these rule calculations to the FOMC, but they are treated as benchmarks, not blueprints.

That flexibility, supporters say, is essential in an economy reshaped by the pandemic, shifting labor patterns, global supply, and constant tariff realignments. As the Fed’s own guidance explains, different rules can produce different rate paths; judgment is needed to weigh which fits the moment.

Still, the government shutdown, which began Oct. 1 and ended Nov. 13, has underscored the limits of data dependence. Without the government’s core economic indicators, the Fed has been forced to rely on private data sources, regional surveys, and anecdotal business reports to fill the gaps. Powell said the committee would “collect every scrap of data we can find” and proceed carefully. “What do you do if you’re driving in the fog?” he asked. “You slow down.”

That fog has made the Fed’s data dependence both more visible and more difficult to evaluate. The central bank says its decisions are guided by the totality of the data, but when asked which data are shaping policy or how heavily each source is weighted, officials have been light on detail. For markets already uneasy about the outlook for inflation, that opacity could become another source of volatility.

The Bureau of Labor Statistics released the September jobs report on Nov. 21, but said it won’t publish an October report.

Former Fed official and potential future Fed Chair Kevin Warsh, a visiting fellow at the Hoover Institution, has argued that the central bank’s data-heavy approach, which also draws on each official’s discretion, makes it difficult for investors to anticipate the Fed’s future moves.

In a recent interview with Politico, National Economic Advisor Kevin Hassett, another contender for Fed Chair, also argued that the Fed’s current process is too cryptic. “An independent Fed is very transparent…it tells you, this is what we think the economy is going to look like,” he said. “They tell you why. They show you their models. They encourage debate about, like, what model is working best right now.”

Hassett, who likened the Fed to “the Wizard of Oz behind the curtain,” nonetheless favors further interest-rate cuts, rather than the hikes or pause that the Taylor rule is signaling.

This past spring, Jason Furman, a former top White House economist and currently a professor at Harvard University, told Barron’s that the Fed relies on an ever-shifting mix of indicators, leaving markets and the public guessing about policy moves. He also advocated for a clearer framework, like the Taylor rule.

John Taylor did not immediately respond to a request for comment.

The Powell Fed says rules serve as important reference points, not as substitutes for judgment. But Powell’s term as chair ends in May, and his successor, whom the Trump administration hasn’t yet nominated, may choose to adopt more of a rules-based system.

The widening gap between rules-based prescriptions and current policy has amplified calls for the Fed to explain its reasoning more clearly. The Taylor rule is far from gospel, but its signal today is unambiguous.

Write to Nicole Goodkind at nicole.goodkind@barrons.com.