All articles 199

11 21 2015 | by Victor Xing | Central Banks

Should the Federal Reserve follow Taylor Rule?

The Taylor Rule

There are indeed several of monetary policy rules that may serve as a guidepost for the Federal Reserve, and the most prominent one is the often-cited Taylor rule by economist John B. Taylor.  It is incorporated into the Federal Reserve’s FRB/US model, one of several macro-economic models used by staff economists at the Federal Reserve Board of Governors in monetary policy analysis.

The FRB/US Model: A Tool for Macroeconomic Policy Analysis (excerpt from the paragraph on “Impulse Responses to Funds Rate and MFP Shocks VAR Expectations vs Model-Consistent Expectations”)

The estimated funds rate equation that is part of the VAR-based expectations mechanism has more inertia than the Taylor-type policy rule used in FRB/US itself for these simulations. As a result, the initial interest rate increase is anticipated to be more persistent under VAR-based expectations than under model-consistent expectations (lower right panel, shown in real terms). Through its effect on real long-term interest rates, this difference causes the output gap and inflation to decline substantially more in the VAR-based case.

[The FRB/US model is freely available for the public: FRB/US model packages]

San Francisco Fed President Williams and John Taylor (holding their respective T-shirts).  President Williams made his “Monetary Policy – It’s Data Dependent” T-shirt as a statement that monetary policy reacts to changing economic conditions (referring to his preference to not state when the Federal Reserve will raise rates)

Taylor Rule and Taylor Rule T-shirt


Optimal monetary policy vs. monetary policy rules

Should the Federal Reserve conduct its monetary policy using the Taylor Rule or simply outputs from the FRB/US model?  There have been contentious debates amongst financial market participants, current and former FED officials, as well as between prominent economists (Professor Shane Greenstein on Quora also outlined his view, which I agree).

I would also like to highlight the opposing views from senior Federal Reserve policymakers.  In her March 2015 speech (Prospects and Perspectives–March 27, 2015), Chair Yellen outlined risks of following simple monetary policy rules (which echoed points made by Professor Greenstein)

Under normal circumstances, simple monetary policy rules, such as the one proposed by John Taylor, could help us decide when to raise the federal funds rate.  Even with core inflation running below the Committee’s 2 percent objective, Taylor’s rule now calls for the federal funds rate to be well above zero if the unemployment rate is currently judged to be close to its normal longer-run level and the “normal” level of the real federal funds rate is currently close to its historical average. But the prescription offered by the Taylor rule changes significantly if one instead assumes, as I do, that appreciable slack still remains in the labor market, and that the economy’s equilibrium real federal funds rate–that is, the real rate consistent with the economy achieving maximum employment and price stability over the medium term–is currently quite low by historical standards.  Under assumptions that I consider more realistic under present circumstances, the same rules call for the federal funds rate to be close to zero.  Moreover, I would assert that simple rules are, well, too simple, and ignore important complexities of the current situation, about which I will have more to say shortly.

In his Systematic Monetary Policy and Communication  Former Philadelphia Fed President Plosser focused on benefits of conducting monetary policy in a systematic (rule-based) manner, arguing in favor of Taylor Rule (or Taylor-like rules).

The Benefits of Systematic Monetary Policy

Let me now turn to the importance of conducting monetary policy in a systematic manner. By systematic policy, I mean conducting policy in a rule-like manner as opposed to relying on discretion. Decisions are always made period by period, but in a rules-based approach, the decisions are guided by the rules. Discretion is the opposite of rules-based decisionmaking. Discretionary decisions are made without being constrained by past promises or previous forward-looking statements.

The monetary policy debate over whether rule-like behavior is preferable to pure discretion dates back at least to Henry Simons in 1936.1 More recently, in their Nobel Prize-winning work, Finn Kydland and Ed Prescott demonstrated that a credible commitment by policymakers to behave in a systematic rule-like manner leads to better outcomes than discretion.2 Since then, numerous papers using a variety of models have investigated the benefits of rule-like behavior in monetary policy and found that there are indeed significant benefits. Policies characterized by commitment have been shown to lead to more economic stability. In fact, the mainstream theoretical models that we use for monetary and macroeconomic analysis are built on the notion that monetary policy is conducted in a rule-like manner.

The benefits of a rule-like approach arise, in part, because consumers and businesses are forward looking. When policymakers credibly commit to a rule-like approach to setting policy, they can alter expectations in ways that make policy more effective and less uncertain.

President Plosser’s comments were echoed by Kansas City Fed President George (another policymaker who favors earlier rate hike).  Below is an excerpt from her May 2014 speech (link)

First, I would like to see short-term interest rates move higher in response to improving economic conditions shortly after completion of the “taper.” Many of the rules offering policy guidance on the federal funds rate—such as the “Taylor rule” and its variants—are already or close to prescribing a policy rate higher than the current funds rate.

In conclusion, conducting monetary policy with systematic rules as a reference (but not as a guide) is favored by senior policymakers in respect to changing economic assumptions in a complex economy.

Next article11 21 2015 | by Victor Xing | Capital Markets

Why is Fixed Income important?