Magazine article Economic Trends

Taylor Rules and Communication

Magazine article Economic Trends

Taylor Rules and Communication

Article excerpt

The FOMC statement continues to assert that "monetary policy remains accommodative," but it is difficult to judge whether or not this is the case. One approach is to calculate what the funds rate would have been in the past under similar conditions. The Taylor rule, which posits that the Federal Reserve sets the funds rate on the basis of inflation and the output gap (deviations of output from potential), provides such a benchmark.

Unfortunately, calculating the Taylor rule also requires one's best guess on the Fed's (implicit) long-term inflation target and on the underlying longterm real funds rate, neither of which is observable. The short-term real funds rate varies substantially over time. Economic theory suggests that the underlying or long-term real funds rate may also vary. For example, it may be affected by both long-term productivity growth and monetary policy.

Since Chairman Greenspan took office, the real funds rate has averaged slightly less than 1.75%, but it could conceivably be as low as 1% or as high as 2.5%. This creates a band of uncertainly around the Taylor rule. The Fed's implicit long-term inflation target is likewise uncertain and plausibly ranges from 1% to 2%, creating another band of uncertainty.

The evidence suggests, however, that the Fed adjusts the funds rate more slowly than the Taylor rule predicts. Instead of adjusting immediately to the rate predicted by the Taylor rule, it appears to adjust only partially. This type of Taylor rule is called inertial because it changes slowly, and today's funds rate depends on yesterday's. Both the regular and the inertial Taylor rule suggest that the recent period of accommodation may have just about ended. According to history, whether the funds rate rises or falls from here depends on future inflation and output behavior.

But why adjust only part way (that is, with inertia)? The funds rate increased 25 basis points at each of the last 10 policy meetings, instead of making five moves of 50 bp each. These moves were arguably predictable, given the unwinding of the earlier monetary stimulus and the unfolding of past energy shocks.

Model simulations suggest that there may be an advantage to adjusting the funds rate slowly. The following pictures answer a hypothetical question: Holding everything else constant, how would inflation, interest rates, and output be expected to behave after a one-time increase in oil prices? How would these variables behave if the Fed followed a non-inertial, rather than an inertial, Taylor rule? …

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