Academic journal article Economic Review (Kansas City, MO)

Was Monetary Policy Optimal during Past Deflation Scares?

Academic journal article Economic Review (Kansas City, MO)

Was Monetary Policy Optimal during Past Deflation Scares?

Article excerpt

Countries around the world have fallen into one of the deepest recessions since the Great Depression--a recession exacerbated by a severe financial crisis. Among the challenges that face monetary policymakers in such uncertain times is the danger economies worldwide, including the United States, Japan, and the euro area, may enter a period of deflation, in which the prices of goods and services fall relentlessly.

Policymakers and economists agree that sustained deflation would likely worsen the already fragile economic and financial environment. Past episodes of deflation in the wake of financial crises have included falling asset values, collapsing business and consumer confidence, credit crunches, widespread bankruptcies, long-lasting surges in unemployment, and other adverse conditions. Moreover, a deflationary environment has the potential to complicate the conduct of monetary policy. Central banks typically counteract slowing economic activity by lowering short-term nominal interest rates. But as policy rates approach zero, conventional tools of monetary policy are no longer available to stimulate economic activity.

Policymakers have responded vigorously to the current crisis to prevent deflation. Some analysts warn that the U.S. policy response might be too proactive and cause a subsequent surge in inflation. At the same time, other analysts advise that the policy response in many other countries might not be active enough to fend off deflation. Of course, it is too early to judge the success of the different policies in the current episode. Still, it is possible to learn from past attempts by policymakers to fend off deflation under similar economic circumstances. One episode occurred in Japan during the early 1990s, when the collapse of an asset-price bubble severely weakened the economy. Another episode occurred in the United States during the early 2000s, when its stock-price bubble burst and the terrorist attacks of September 11,2001 shocked the economy.

One way to evaluate monetary policy is to compare it with the recommendations of Taylor rules. A Taylor rule prescribes a setting for a central bank's policy rate based on observed inflation and output. At a number of central banks, policymakers use Taylor rules, along with other types of guidelines, as inputs into their evaluation of the appropriate stance of monetary policy.

This article shows how Taylor rules can be used to evaluate monetary policy. It then compares actual policy during the Japanese and U.S. deflation scares with how policy would have been conducted using Taylor rules based, to the extent possible, on data available at the time. The rule-based evidence suggests that Japan's monetary policy response during the early 1990s might have been too weak, while the U.S. response during the early 2000s might have been too strong.

The first section of the article describes the policy rule proposed by Taylor as well as different versions, which collectively are called Taylor rules. The second section uses Taylor rules to evaluate Japan's monetary policy from 1990 to 1995. The third section uses the rules to evaluate U.S. monetary policy from 2000 to 2005.


In 1993, at the Carnegie Rochester conference, John Taylor first proposed the Taylor rule. The rule was a simple equation for central banks to use as a guideline for systematically changing the level of the policy rate in response to changes in inflation and output. Since then, economists have modified Taylor's original proposal. One type of modification was aimed at achieving optimal economic performance. This section describes the original and optimal Taylor rules, as well as their limitations.

General description

Taylor rules provide guidelines for central banks setting policy rates in response to changes in a small number of factors that broadly summarize the state of the economy. Taylor rules often take the form:

(1) [i. …

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