Which Simple Rule for Monetary Policy?

The discussion of “Simple Rules for Monetary Policy” at last week’s FOMC meeting is a promising sign of a desire by some to return to a more rules-based policy. As described in the FOMC minutes, the discussion was about many of the questions raised in recent public speeches by FOMC members Janet Yellen and Bill Dudley. A big question is which simple rule?

Yellen and Dudley discussed two rules. Using Yellen’s notation these are

R = 2 + π + 0.5(π – 2) + 0.5Y
R = 2 + π + 0.5(π – 2) + 1.0Y

where R is the federal funds rate, π is the inflation rate, and Y is the GDP gap. Yellen and Dudley refer to the first equation as the Taylor 1993 Rule and the second equation as the Taylor 1999 Rule, though the second equation was only examined along with other rules, not proposed or endorsed, in a paper I published in 1999.

The two rules are similar in many ways. Both have the interest rate as the instrument of policy, rather than the money supply. Both are simple, having two and only two variables affecting policy decisions. Both have a positive weight on output. Both have a weight on inflation greater than one. Both have a target rate of inflation of 2 percent. Both have an equilibrium real interest rate of 2 percent.

The two rules differ substantially, however, in their interest rate recommendations as this amazing chart constructed last April by Bob DiClementi of Citigroup illustrates. The chart shows two rules along with historical and projected values of the federal funds rate. The rule labeled “Taylor” by DiClementi is the rule I proposed. The other rule is labeled “Yellen” by DiClementi because it corresponds to the rule apparently favored by Yellen. The projectd values are the views of FOMC members.

Observe that the first rule never gets much below zero, while the second rule drops way below zero during the recent recession and delayed recovery. The difference continues though it gets smaller into the future. Note that the projected interest rates by FOMC members span the two rules.

This big difference between the two rules in the graph can be traced to two factors: (1) The second rule has a much larger GDP gap, at least as used by Yellen. (2) The second rule has a much bigger coefficient on the GDP gap.

In my view, a smaller value of the GDP gap and a smaller coefficient are more appropriate. This view is based on a survey of estimated gaps by the San Francisco Fed and simulations of models over the years. But given the striking differences in DiClememti’s chart, more research on the issue by people in and out of the Fed would certainly be very useful.

About John B. Taylor 117 Articles

Affiliation: Stanford University

John B. Taylor is the Mary and Robert Raymond Professor of Economics at Stanford University and the Bowen H. and Janice Arthur McCoy Senior Fellow at the Hoover Institution. He formerly served as the director of the Stanford Institute for Economic Policy Research, where he is now a senior fellow, and he was founding director of Stanford's Introductory Economics Center.

Taylor’s academic fields of expertise are macroeconomics, monetary economics, and international economics. He is known for his research on the foundations of modern monetary theory and policy, which has been applied by central banks and financial market analysts around the world. He has an active interest in public policy. Taylor is currently a member of the California Governor's Council of Economic Advisors, where he also previously served from 1996 to 1998. In the past, he served as senior economist on the President's Council of Economic Advisers from 1976 to 1977, as a member of the President's Council of Economic Advisers from 1989 to 1991. He was also a member of the Congressional Budget Office's Panel of Economic Advisers from 1995 to 2001.

For four years from 2001 to 2005, Taylor served as Under Secretary of Treasury for International Affairs where he was responsible for U.S. policies in international finance, which includes currency markets, trade in financial services, foreign investment, international debt and development, and oversight of the International Monetary Fund and the World Bank. He was also responsible for coordinating financial policy with the G-7 countries, was chair of the working party on international macroeconomics at the OECD, and was a member of the Board of the Overseas Private Investment Corporation. His book Global Financial Warriors: The Untold Story of International Finance in the Post-9/11 World chronicles his years as head of the international division at Treasury.

Taylor was awarded the Alexander Hamilton Award for his overall leadership in international finance at the U.S. Treasury. He was also awarded the Treasury Distinguished Service Award for designing and implementing the currency reforms in Iraq, and the Medal of the Republic of Uruguay for his work in resolving the 2002 financial crisis. In 2005, he was awarded the George P. Shultz Distinguished Public Service Award. Taylor has also won many teaching awards; he was awarded the Hoagland Prize for excellence in undergraduate teaching and the Rhodes Prize for his high teaching ratings in Stanford's introductory economics course. He also received a Guggenheim Fellowship for his research, and he is a fellow of the American Academy of Arts and Sciences and the Econometric Society; he formerly served as vice president of the American Economic Association.

Before joining the Stanford faculty in 1984, Taylor held positions as professor of economics at Princeton University and Columbia University. Taylor received a B.A. in economics summa cum laude from Princeton University in 1968 and a Ph.D. in economics from Stanford University in 1973.

Visit: John Taylor's Page, Blog

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