Magazine article Economic Trends

Sizing Up Current Monetary Policy with the Taylor Rule

Magazine article Economic Trends

Sizing Up Current Monetary Policy with the Taylor Rule

Article excerpt

09.06.11

Along with July's advanced estimate for second-quarter GDP, the annual revisions for previous GDP estimates were released. Revisions showed a dramatically lower path for GDP than had been previously estimated. In fact, after revisions, real GDP is now believed to still be below pre-recession levels.

This deeper dip in GDP is a more accurate picture of the actual economic conditions experienced throughout the recession. Less dramatically, inflation as measured by core PCE inflation was also revised.

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We look at how these revisions could impact policy using what is known as the Taylor rule. The Taylor rule is one of the most common tools used to evaluate Fed policy. The rule supposes that the Fed increases rates when inflation increases and decreases rates when the output gap gets larger (the output gap is the difference between potential and actual GDP). We calculate what the rule suggests the federal funds rate should be and compare it to actual rates to get some insight into monetary policy decision making.

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We estimate the rule using the four-quarter change in the core PCE price index as our measure of inflation and a traditional calculation for our measure of the output gap. That traditional calculation shows by what percentage output is above or below its potential. Since potential output is unobservable, we use the Congressional Budget Office's August 2011 estimates for it. The revisions to GDP have so far had a very minimal impact on those estimates, so our output gap calculation has declined since 2010. It is possible that the CBO will revise down its potential estimates at some future date.

Results are shown in the chart below. They indicate that policy has been constrained by the zero lower bound since the end of 2008. Before the GDP revisions and without the zero lower bound restriction, the Taylor rule suggests that the federal funds rate should have been approximately 2 percentage points lower than it was, that is, around -2 percent. After the revisions, the large increase in the output gap suggests that the rate should be 3 percentage points lower than it is currently. That is, the revisions themselves would cause nearly a 1 percentage point drop in the rule's estimate for the interest rate.

At the August Federal Open Market Committee meeting, which occurred shortly after these revisions, the committee strengthened its forward-looking guidance and replaced its "extended period" language with "The Committee currently anticipates that economic conditions--including low rates of resource utilization and a subdued outlook for inflation over the medium run--are likely to warrant exceptionally low levels for the federal funds rate at least through mid-2013. …

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