No, Inflation Does Not Mean Cutting Interest Rates.
Global economic literacy has hit a twenty-first-century low. Here's why the Taylor Principle forbids rate cuts during inflation.
Today, Chair Powell had to explicitly state that President Trump’s tariffs will create “higher inflation and slower growth”. The fact that the Fed Chairman had to explain basic economics to the mightiest man on Earth and his supporters shows that even the smallest amount of economic literacy is probably dead.
I had discovered Powell’s remarks on the Financial Times’ instagram page, and that’s exactly the same place where I was inspired to write this short educational explanation.
To all part-time economists in the comments of that instagram post:
Inflation or expected inflation cannot be reduced through rate cuts—here's why
The Taylor Rule
The Taylor Rule is a foundational rule in monetary policy, named after economist John B. Taylor. It provides a guideline for central banks on how to adjust interest rates in response to changes in economic conditions, particularly inflation and economic output. At its core, the Taylor Rule emphasizes a straightforward but critical idea: when inflation rises, interest rates must rise proportionally—not fall—to maintain economic stability.
The original 1993 formulation calculates the target nominal interest rate as:
where pi is the actual inflation rate, pi-star the target inflation rate, r-star the equilibrium real interest rate and y (sometimes written as Y minus Y-star) the output gap.
This formula is brilliant since it shows the Fed’s commitment to the Dual Mandate, their duty to ensure long-term price stability and maximum employment.
The Standard New Keynesian Model
Nowadays, economists prefer to use a more generalized form of the Taylor rule in a New Keynesian model1:
First, let me introduce the New Keynesian Phillips Curve (or NKPC):
The NKPC describes inflation dynamics, which depend on expectations, not just past inflation. pi_t is inflation at time t, E_t pi_{t+1} is expected inflation of next period t+1 using information in t, beta is the discount factor, kappa is some positive number representing the slope of the NKPC (depends on how “sticky” the prices are) and u_t a cost-push shock (supply-side inflation).
Second, the Dynamic IS Curve:
The IS curve shows that demand depends on real interest rates and expectations.
E_t y_{t+1} is the expected output gap of next period t+1 using information in t, i_t is the nominal interest rate in t, r^n_t is the natural real interest rate (the neutral rate that keeps the economy stable—balancing savings and investment at full employment with stable inflation) and sigma the intertemporal elasticity of substitution (imagine sigma as your "itchiness to spend now vs. later", low sigma values close to zero mean rate cuts mean nothing to you, bigger values mean you go wild whenever interest rates drop).
The third and final key equation is our beloved Taylor rule:
where the two phis are the respective policy coefficients.
Now that we've established the New Keynesian framework, let's examine how the system responds when inflation or inflation expectations increase. The key mechanism at work here is the Taylor Principle, which requires the central bank to respond aggressively to rising inflation.
Imagine an unexpected surge in inflation occurs, perhaps due to a supply chain disruption or a sudden spike in demand. This sets off a chain reaction:
Here pi rises, and if expectations adjust (increase) the New Keynesian Phillips Curve implies that inflation could persist or even accelerate. Meanwhile, the IS Curve tells us:
If the central bank doesn't act, higher inflation expectations reduce the real interest rate (nominal interest rate minus expected inflation), stimulating demand and further fueling inflation.
Naturally, the central bank responds, following the Taylor Rule to set the nominal interest rate:
The critical part of this rule is the coefficient phi_pi which dictates how aggressively the central bank responds to inflation deviations from its target. For stability the Taylor Principle requires
When inflation rises, the central bank raises the nominal interest rate more than one-for-one. This ensures the real interest rate increases:
A higher real rate discourages borrowing and spending, cooling demand and, through the NKPC, reducing inflation:
The Taylor Principle, i.e. increasing the nominal interest rate more than one-for-one with inflation, is strictly necessary. If the central bank were to have an inflation policy coefficent stricly less than 1, then:
The real interest rate would fall, when inflation rises, exacerbating the problem.
This leads to a vicious cycle of rising inflation and expectations.
Conversely, with phi_pi > 1, the system self-stabilizes:
Higher inflation leads to higher real rates, higher real rates lead to lower demand and lower demand leads to lower inflation.
If people expect future inflation to rise, the Taylor Rule automatically tightens policy today to prevent a wage-price spiral. This is how credible central banks anchor expectations and maintain stability.
The Taylor Principle ensures that when inflation rises, the central bank raises rates aggressively enough to actually tighten financial conditions. Fail to do this, and inflation spirals out of control. Do it right, and the economy returns to stability.
That is why Chair Powell and the Federal Open Market Committee are certainly not considering cutting rates to fight inflation, regardless of what Instagram commenters recommend.
The standard New Keynesian model is log-linearized around a steady state for tractability. This approximation works well for small fluctuations but abstracts away from nonlinear effects (e.g., large shocks, asymmetric dynamics). Below is the canonical NK framework in its log-linearized form, which underpins modern monetary policy analysis, including the Taylor Rule.