Tag Archives: Taylor rule

Arguments Against Strict Monetary Policy Rules

In its July 2017 Monetary Policy Report, the Board of Governors of the Federal Reserve System discusses monetary policy rules. On pp. 36–38, the Board argues that

[t]he small number of variables involved in policy rules makes them easy to use. However, the U.S. economy is highly complex, and these rules, by their very nature, do not capture that complexity. …

Another issue related to the implementation of rules involves the measurement of the variables that drive the prescriptions generated by the rules. For example, there are many measures of inflation, and they do not always move together or by the same amount. …

In addition, both the level of the neutral real interest rate in the longer run and the level of the unemployment rate that is sustainable in the longer run are difficult to estimate precisely, and estimates made in real time may differ substantially from estimates made later on …

Furthermore, the prescribed responsiveness of the federal funds rate to its determinants differs across policy rules. …

Finally, monetary policy rules do not take account of broader risk considerations. … asymmetric risk has, in recent years, provided a sound rationale for following a more gradual path of rate increases than that prescribed by policy rules.

Fiscal-Monetary Policy Interaction

In the Richmond Fed’s Econ Focus, Eric Leeper explains his views.

  • Disparate confounding dynamics and simple policy rules:

    My view is that central banks have put far too many resources into understanding tiny fluctuations and too few resources into the things that actually matter. …

    Something like the basic Taylor rule doesn’t really serve as a useful litmus test for what policy is doing in the face of these DCDs, so it’s a little bizarre to me that a lot of central banks routinely calculate what the path of the interest rate would be with a simple Taylor rule as if that’s a useful benchmark. It’s not obvious to me what that’s a benchmark for.

  • Active/passive policy regimes, the fiscal theory of the price level and whether current or previous policy mixes are or were characterized by active fiscal policy:

    Now, how all of [current policy] ties into the active/passive framework is really an open question. A lot of it depends on what you think is going to happen to the Fed’s balance sheet.

    … the recovery from the Great Depression in 1933 when Roosevelt took the United States off the gold standard. Going off the gold standard converted government debt from effectively real debt to nominal debt because the price level under the gold standard was beyond the control of the government. At the same time, the fiscal actions Roosevelt undertook were what nowadays we would call an unbacked fiscal expansion. … This is like a fiscal rule that says the government will run deficits until the price level recovers to some pre-depression level. And the Fed was just keeping the interest rate flat. So it looked a lot like passive monetary/ active fiscal.

  • Walls between monetary and fiscal policy:

    The thing is, there’s not a lot of theoretical justification for creating these walls. What we’re finding more and more is that there’s always some role in optimal policy for using surprise inflation to revalue debt and bond prices, so long as there is some maturity to government debt. … maybe it is a slippery slope once you’re in the political realm. But from an academic perspective, if your objective is to arrive at a rule that would be mechanically followed by a central bank, then there’s no harm in having fiscal variables enter that rule.

The Fed Oversight Reform and Modernization (FORM) Act

On Econbrowser, Carl Walsh critically discusses H.R. 3189, The Fed Oversight Reform and Modernization (FORM) Act. He points out that the output gap measure in a policy rule plays an important role.

He writes:

Legislating a rule for the Fed’s instrument as a means of constraining its discretion and holding it accountable for its policy actions represents a fundamental shift from a policy such as inflation targeting. Under inflation targeting, the central bank is held accountable for meeting a target that represents an ultimate goal of monetary policy – low inflation – rather than for moving its policy instrument consistent with a specific rule. …

Using an estimated DSGE model, I find that the optimal weights to place on goal-based inflation and rule-based Taylor rule performance measures depend importantly on the output measure employed in the rule. When the rule is similar to that proposed recently in U.S. H.R. 3189, I find the optimal weight to assign to the rule-based performance measure is always equal to zero – that is, the rule H.R. 3189 proposed would lead to inferior macroeconomic outcomes and should not be used.

This result is largely driven by the fact that the definition of output used in the legislated rule – output relative to trend – is not consistent with the definition of output the theory behind the model I use would imply – output relative to its efficient level. When the Taylor rule is modified to use the measure of economic activity that is more consistent with basic macro theory, outcomes can be improved by making deviations from such the rule a part of a system for accessing the Fed’s performance and promoting its accountability.

Do Higher Nominal Interest Rates Raise Inflation?

In several blog posts (here and here), John Cochrane mulls over the Fisher equation and the stability properties of the variables in the equation:

I think I can boil down the issue to this question: If the central bank pegs the nominal rate at a fixed value, is the economy eventually stable, converging to the interest rate peg minus the real rate? Or is it unstable, careening off to hyperinflation or deflationary spiral?

He offers a series of instructive graphs to illustrate the inflation dynamics under the assumption that inflation dynamics are (i) stable (Neo-Fisherian view) or (ii) unstable (standard view):


Interest rate increase pushes up inflation, maybe with a delay.


Inflation shock eventually dies out even if interest rate does not respond.


Interest rate increase pushes down inflation, on an accelerating path …


… unless monetary policy steps in and undoes the initial tightening.


Inflation shock does not die out …


… unless the interest rate responds.

Which model is the right one? The US, Japan and other countries have been at the zero lower bound for a while—without an explosion in inflation. John Cochrane interprets this fact as evidence in favour of stability. And he offers this nice analogy:

Think of holding a broom upside down. That’s the standard view of interest rates (on the broom handle) and inflation (the broom). Anytime the Fed sees inflation moving, it needs to quickly move interest rates even more to keep inflation from toppling over — the Taylor rule. To raise inflation, the Fed needs first to lower interest rates, get the broom to start toppling in the inflation direction, then swiftly raise rates, finally raising them even more to re-stabilize the broom.

The neo-Fisherian view says the Fed is holding the broom right side up, though perhaps in a gale. To move the bottom to the left, move the top to the left, and wait. But alas, the broom sweeper has thought it was unstable all these years, so has been moving the handle around a lot.