First we should check to see whether the Taylor Rule calculation is correct. Starting with the Taylor Rule formula
TRFFR = INFR + 2.0 + 0.5 ( INFR - 2.0 ) - 0.5 ( UEMR - 6.0 )
where TRFFR is the level the federal funds rate should be set at according to the Taylor Rule, and INFR and UEMR are the inflation and unemployment rates, we simply substitute in INFR = 1.5 and UEMR = 7.0 . This yields a value of TRFFR equal to 2.75 which is 1.25 percentage points below the current federal funds rate. Taken by itself, this calculation suggests that monetary policy is too tight.
Nevertheless, we must be careful not to simply mechanically apply the rule! The inflation rate is below the target of 2.0 percent which by itself suggests a more expansionary policy policy. And the unemployment rate is 1 percentage point above its normal full-employment level, also suggesting that a more expansionary monetary policy would be appropriate. Nevertheless, it would seem useful to have a look at the time paths of the inflation and unemployment rates over the previous few quarters. Has the unemployment rate been falling and the inflation rate rising? Or has the opposite been occurring? If the recent movements in the variables have been in the desired direction, it might be worth while to wait for a quarter to see if the desired in inflation and unemployment rates will occur as a result of present policy. Alternatively, if the inflation and unemployment rates have been moving from the desired levels, further downward pressure on the federal funds rate would seem appropriate.
Another issue of interest is whether the rest of the world has been expanding slower than the United States in recent quarters, causing the real exchange rate to rise and shifting world demand onto U.S. output. This raises the question of whether further U.S. monetary expansion is necessary to achieve full employment and price level stability---it still may be the case that the eventual contribution of past monetary expansion may be sufficient to enable the attainment of the U.S. inflation and unemployment rate objectives. In this regard, it is useful to look at current relative to past rates of money growth---has there been an enormous recent expansion of the domestic stock of base money that has not yet had its full impact on interest rates and output?
Also, the question arises as to whether 6 percent is an appropriate long-run unemployment rate objective, and whether moving the inflation rate down by half a percentage point or more would be desirable. And is there any evidence that real interest rates have increased, so that the 2.0 in the equation should be raised to 2.5 or 3.0?
The crucial point that must be recognized here is that appropriate policy action requires that the Federal Reserve authorities use judgment. A Taylor Rule is useful by focusing attention on the crucial issues and providing a quantitative estimate of what might be desirable under certain circumstances, but the exercise of judgment is absolutely necessary!