Academic journal article Economic Review - Federal Reserve Bank of Kansas City

Estimated Rules for Monetary Policy

Academic journal article Economic Review - Federal Reserve Bank of Kansas City

Estimated Rules for Monetary Policy

Article excerpt

(ProQuest: ... denotes formulae omitted.)

Estimated policy rules describe how monetary policy has responded in the past to key economic indicators. Based on economic conditions and policy objectives, estimated rules can be used to evaluate past policy decisions and the outcomes of those decisions. In conjunction with "optimal" rules that economists derive from economic models and simple rules that approximate optimality in a range of models, estimated rules can help guide policymakers' assessment of the current stance of monetary policy and the appropriate path for policy.

But estimated rules are useful only to the extent they can describe policy choices that, in retrospect, turned out to be good or can help policymakers learn from policy choices that turned out to be bad. For example, if a period of favorable macroeconomic performance can be attributed to good monetary policy, policymakers may benefit from understanding what factors drove policy decisions over that period and by trying to systematically replicate that behavior. In contrast, if monetary policy actions led to unsatisfactory outcomes, policymakers should try to understand what went wrong and fix it.

This article estimates policy rules over periods of favorable economic performance to derive benchmark rules that might be useful guides for future monetary policy. Section I describes two simple, nonestimated rules that have been proposed as guides for policy and examines how closely they describe the actual setting of policy over various periods. Section II identifies time periods over which macroeconomic performance has generally been favorable and estimates policy rules that describe how monetary policy responded to key indicators over these periods. Section III evaluates past and current policy relative to the estimated rule and gives a number of reasons why policymakers should remain cautious about blindly following any estimated rule.

The article concludes that a rule that puts somewhat greater weight on inflation than output in determining a setting for the federal funds rate has worked well in the past and could be a useful guide in the future. However, some of the unique features of the current economic situation-including a binding zero lower bound on interest rates and a desire to manage downside risk to the outlook for economic activity- may suggest a need for flexibility in following the prescription of any rule based on past performance.


Central banks have long relied on rules to help guide monetary policy. However, the use of simple feedback rules that prescribe a setting for the policy interest rate as a function of a few key economic indicators accelerated sharply with the rule that Stanford University economics professor John Taylor formulated in 1992 and published in 1993.1 Since then, a number of variants have been proposed. Most of these rules recommend a setting for the federal funds rate-the interest rate banks charge each other for overnight loans of reserves and the rate that the Federal Open Market Committee (FOMC) targets-based on inflation relative to a target inflation rate and some measure of real economic activity. The surprising feature of these simple rules is how well many of them match the actual path of the federal funds rate.

The most well-known rule is the Taylor 1993 rule, which sets the federal funds rate as a function of inflation relative to a target of 2 percent and the output gap. The output gap is the difference between real GDP and potential real GDP expressed as a percentage of potential real GDP. Given Taylor's parameterization, the rule can be written as follows:

... 1.A

... 1.B

where ffr is the nominal federal funds rate, p is the inflation rate as measured by the GDP deflator, y is the output gap, and (p - 2) represents inflation relative to its assumed 2 percent target. Thus, when inflation is at its target of 2 percent and real GDP is at potential (y = 0), the rule says that the nominal federal funds rate should be set at 4 percent. …

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