Share |

A Useful Rule for Monetary Policy

Peter Ireland | 07/24/2014 |
Shadow Federal Reserve

A classic question resurfaced last week during Federal Reserve Chair Janet Yellen’s Semi-Annual Monetary Policy Report to Congress: should interest rates be set according to a simple rule? Some members of the House of Representatives think so, and have drafted a new, “Federal Reserve Accountability and Transparency Act” that reflects their belief.

Importantly, this bill does not require Fed officials to blindly and mechanically set interest rates as dictated by a single mathematical equation. But it does require them to seriously consider such a rule in their deliberations and to explain any large or persistent departure they take from the setting prescribed by that rule. Nor does the proposed Act specify the particular rule that the Fed ought to follow: that choice is left for Fed policymakers themselves to make. But the bill does ask the Fed to compare its own rule to the benchmark “Taylor rule” for monetary policy.

Named after economist John Taylor, who introduced the equation in a famous article published in 1993, the Taylor rule sets the federal funds rate r with reference to the difference between inflation p over the preceding 12 months and the Fed’s target rate p* and the percentage gap between actual GDP y (measured, for the mathematically-inclined, in logarithms) and potential output y* (also in logs) according to

r = p + (1/2)(p−p*) + (1/2)(y−y*) + 2.

Though somewhat cryptic in its algebraic form, the Taylor rule becomes more intuitive when described in words. Suppose that inflation equals target and GDP is right at potential, so that the economy is neither booming nor in recession. Then, with p=p* and y=y*, the Taylor rule recommends a set of r=p*+2 for the funds rate. Thus, given the Fed’s two-percent target for inflation, the Taylor rule identifies 4 percent as the normal, or neutral, level for the funds rate. Then, from that starting point, the Taylor rule calls for the Fed to either raise or lower the funds rate as inflation rises above or falls below target and as GDP rises above or falls below potential.

Even without the Accountability and Transparency Act, the Fed could use the Taylor rule as a valuable communications device, to better explain the rationale behind its decisions. To illustrate how, the figure below compares the interest rate prescribed by the Taylor rule to the actual level of the federal funds rate as both have evolved since 2006. The figure uses the GDP deflator, Taylor’s own choice, to measure inflation, but replaces his linear trend for potential GDP with the Congressional Budget Office’s more sophisticated measure to better account for the very slow growth experienced in the US over this entire period.

Strikingly, the graph shows that the Fed followed the Taylor rule almost exactly by rapidly lowering its funds rate target as the economy weakened and fell into recession during 2007 and 2008. Even more strikingly, however, the graphs reveals that with inflation well below target and output far below potential during 2009 and 2010, the theoretical Taylor rule called for the impossible: substantially negative interest rates. During this period, when many observers assumed that the Fed’s zero interest rate policy meant that monetary policy was enormously accommodative, the Taylor rule told us instead that monetary policy was too tight! The Fed might then have used the Taylor rule to explain more clearly the need for at least some of the unconventional steps it took to provide further stimulus during the depths of the recession.

More recently, the slow but still meaningful economic recovery has pushed the interest rate implied by the Taylor rule back into positive territory. Still, the graph provides Fed officials with support to argue that, by keeping the funds rate at zero, they have reasonably provided the modest amount of additional stimulus needed to make up for the shortfall experienced earlier. Thus, even when the Fed departs from the Taylor rule, it could use the equation to help explain why.

Finally, as the recovery continues to gain steam in the months ahead, inflation will return towards two percent, real GDP will converge back to potential, and the Taylor rule will call for more substantial hikes in the funds rate target. Higher interest rates are never popular, but when the time comes, the Fed can use the Taylor rule to make clear that those rate increases are necessary to bring monetary policy back to its normal, long-run stance and prevent excessive inflation. Thus, in good times as in bad, the Taylor rule would help the Fed explain its policies to lawmakers and the American public.

 

 

The red line tracks the setting for the federal funds rate prescribed by the Taylor rule; the blue line shows the actual path of the federal funds rate.

 

Peter Ireland is a professor of economics at Boston College and a member of the Shadow Open Market Committee.

Interested in real economic insights? Want to stay ahead of the competition? Each weekday morning, e21 delivers a short email that includes e21 exclusive commentaries and the latest market news and updates from Washington. Sign up for the e21 Morning eBrief.


e21 Projects & Partnerships