A simple formula that prescribes a policy rate from inflation and the output or unemployment gap; used as a benchmark for whether policy is tight or loose.
The classic form sets the policy rate equal to the neutral-rate plus inflation, plus one half times the inflation gap, plus one half times the output gap. It is not a rule anyone follows mechanically, but it is a useful reference point for whether the stance is unusually restrictive.
Its weakness is that both the neutral rate and the output gap are unobservable and revised heavily after the fact, so the prescription can move by a percentage point on data revisions alone.
Example: neutral real rate 0.5%, inflation 3.0%, target 2.0%, output gap plus 1.0%. The rule gives 0.5 + 3.0 + 0.5 x (3.0 - 2.0) + 0.5 x 1.0 = 4.5%. If the actual policy rate is 4.375%, policy is roughly rule-consistent.
Original diagrams for the ideas on this page. Illustrative, not real market data.
Risk and reward on one trade. One trade on a price scale: the entry sits 2.00 points above the stop and 6.00 points below the target, so the shaded reward band is three times the risk band. The ratio compares what is lost if the stop is hit with what is gained if the target is reached.
Educational only, not advice. Spotted an error? Post in Site Feedback.