Board of Governors of the Federal Reserve System

Overview

Monetary policy rules are mathematical formulas that relate a policy interest rate, such as the federal funds rate, to a small number of other economic variables--typically including the deviation of inflation from its target value along with an estimate of resource slack in the economy. Policy rules can provide helpful guidance for policymakers. Indeed, since 2004, prescriptions from policy rules have been included in written materials that are routinely sent to the Federal Open Market Committee (FOMC). However, interpretation of the prescriptions of policy rules requires careful judgment about the measurement of the inputs to the rules and the implications of the many considerations that the rules do not take into account.

Policy rules can incorporate key principles of good monetary policy.¹ One key principle is that monetary policy should respond in a predictable way to changes in economic conditions. A second key principle is that monetary policy should be accommodative when inflation is below the desired level and employment is below its maximum sustainable level; conversely, monetary policy should be restrictive when the opposite holds. A third key principle is that, to stabilize inflation, the policy rate should be adjusted by more than one-for-one in response to persistent increases or decreases in inflation.

Economists have analyzed many monetary policy rules, including the well-known Taylor (1993) rule. Other rules include the "balanced approach" rule, the "adjusted Taylor (1993)" rule, the "price level" rule, and the "first difference" rule (figure A).² These policy rules reflect the three key principles of good monetary policy noted earlier. Each rule takes into account estimates of how far the economy is from achieving the Federal Reserve's dual-mandate goals of maximum employment and price stability.

Four of the five rules include the difference between the rate of unemployment that is sustainable in the longer run and the current unemployment rate (the unemployment rate gap); the first-difference rule includes the change in the unemployment gap rather than its level.³ In addition, four of the five rules include the difference between recent inflation and the FOMC's longer-run objective (2 percent as measured by the annual change in the price index for personal consumption expenditures, or PCE), while the price-level rule includes the gap between the level of prices today and the level of prices that would be observed if inflation had been constant at 2 percent from a specified starting year (PLgap_t).⁴ The price-level rule thereby takes account of the deviation of inflation from the long-run objective in earlier periods as well as the current period. Thus, if inflation had been running persistently above 2 percent, the price-level rule would prescribe a higher level for the federal funds rate than rules that use the current inflation gap. Likewise, if inflation had been running persistently below 2 percent, the price-level rule would prescribe setting the policy rate lower than rules that use the current inflation gap.

The adjusted Taylor (1993) rule recognizes that the federal funds rate cannot be reduced materially below zero, and that following the prescriptions of the standard Taylor (1993) rule after a recession during which interest rates have fallen to their lower bound may, for a time, not provide enough policy accommodation. To make up for the cumulative shortfall in accommodation (Z_t), the adjusted rule prescribes only a gradual return of the policy rate to the (positive) levels prescribed by the standard Taylor (1993) rule after the economy begins to recover. The particular price-level rule specified in figure A also recognizes that the federal funds rate cannot be reduced materially below zero. If inflation runs below the 2 percent objective during periods when the rule prescribes setting the federal funds rate well below zero, the price-level rule will, over time, provide accommodation to make up for the past inflation shortfall.

The U.S. economy is complex, and the monetary policy rules shown in figure A do not capture many elements that are relevant to the conduct of monetary policy. Moreover, as shown in figure B, different monetary policy rules often offer quite different prescriptions for the federal funds rate.⁵ In practice, there is no unique criterion for favoring one rule over another. In recent years, almost all of the policy rules shown have called for rising values of the federal funds rate, but the pace of tightening that the rules prescribe has varied widely.

Uncertainty about the neutral interest rate in the longer run

The Taylor (1993), balanced-approach, adjusted Taylor (1993), and price-level rules provide prescriptions for the level of the federal funds rate; all require an estimate of the neutral real interest rate in the longer run (Rt ^LR)--that is, the level of the real federal funds rate that is expected to be consistent, in the longer run, with maximum employment and stable inflation.⁶ The neutral real interest rate in the longer run is determined by structural features of the economy and is not observable. In addition, its value may vary over time because of fluctuations in trend productivity growth, changing demographics, and other shifts in the structure of the economy. As a result, estimates of the neutral real interest rate in the longer run made today may differ substantially from estimates made later.

Academic studies have estimated the longer-run value of the neutral real interest rate using statistical techniques to capture the variations among inflation, interest rates, real gross domestic product, unemployment, and other data series. The range of estimates is wide but suggests that the neutral real rate has declined since the turn of the century (figure C).⁷ There is substantial statistical uncertainty surrounding each estimate of the longer-run value of the neutral real rate, as evidenced by the width of the 95 percent uncertainty bands for the estimated values in the first quarter of 2018 (figure D).

D. Point estimates and uncertainty bands for neutral real rate in the longer run as of 2018:Q1

The longer-run normal level of the federal funds rate under appropriate monetary policy--equal to the sum of the neutral real interest rate in the longer run and the FOMC's 2 percent inflation objective--is one benchmark for evaluating the current stance of monetary policy. Uncertainty about the longer-run value of the neutral real interest rate leads to uncertainty about how far the current federal funds rate is from its longer-run normal level. For the Taylor (1993), balanced-approach, adjusted Taylor (1993), and price-level rules, different estimates of the neutral real interest rate in the longer run translate one-for-one to differences in the prescribed setting of the federal funds rate. As a result, the substantial statistical uncertainty accompanying estimates of the neutral rate in the longer run implies substantial uncertainty surrounding the prescriptions of each policy rule. Following the prescriptions of a policy rule with an incorrect value of the neutral rate could lead to poor economic outcomes.

If the longer-run value of the neutral real interest rate is currently at the low end of the range of estimates, then monetary policy is more likely to be constrained by the lower bound on nominal interest rates in the future. Historically, the FOMC has cut the federal funds rate by 5 percentage points, on average, during downturns in the economy. Cutting the federal funds rate by this much in response to a future economic downturn may not be feasible if the neutral federal funds rate is as low as most of the estimates suggest. As a result, it may not be feasible to provide the levels of accommodation prescribed by many policy rules, potentially leading to elevated unemployment and inflation averaging below the Committee's 2 percent objective.⁸ Rules that try to offset the cumulative shortfall of accommodation posed by the lower bound on nominal interest rates, such as the adjusted Taylor (1993) rule, or make up the cumulative shortfall in the level of prices, such as the price-level rule, are intended to mitigate the effects of the lower bound on the economy by providing more accommodation than prescribed by rules that do not have these makeup features.⁹

In the years following the financial crisis, with the federal funds rate close to zero, the FOMC recognized that it would have limited scope to respond to an unexpected weakening in the economy by lowering short-term interest rates. This risk has, in recent years, provided a sound rationale for following a more gradual path of rate increases than that prescribed by some policy rules. In these circumstances, increasing the policy rate quickly in order to have room to cut rates during an economic downturn could be counterproductive because it might make a downturn more likely to happen.

The financial crisis that began in 2007 triggered the deepest recession in the United States since the Great Depression. In response, the Federal Open Market Committee (FOMC) cut its target for the federal funds rate to nearly zero by late 2008. Other short-term interest rates declined roughly in line with the federal funds rate. Additional monetary stimulus was necessary to address the significant economic downturn and the associated downward pressure on inflation. The FOMC undertook other monetary policy actions to put downward pressure on longer-term interest rates, including large-scale purchases of longer-term Treasury securities and agency-guaranteed mortgage-backed securities.

These policy actions made financial conditions more accommodative and helped spur an economic recovery that has become a long-lasting economic expansion. The unemployment rate has declined from 10 percent to less than 4 percent over the course of the recovery and expansion, and inflation has been low and fairly stable. The FOMC's actions were critical to fostering progress toward maximum employment and stable prices--the statutory goals for the conduct of monetary policy established by the Congress.

The Federal Reserve's large-scale asset purchases had the side effect of generating a sizable increase in the supply of reserve balances, which are the balances that banks maintain in their accounts at the Federal Reserve.¹ From the onset of the financial crisis in August 2007 until October 2014, when the FOMC ended the last of its asset purchase programs, the supply of reserve balances rose from about $15 billion to about $2-1/2 trillion.² Reserve balances rose well above the level necessary to meet reserve requirements, thus swelling the quantity of excess reserves held by the banking system.

As the economic expansion continued and unemployment declined--and with labor market conditions projected to continue improving--the FOMC decided that it would scale back policy support by increasing the level of short-term interest rates and by reducing the Federal Reserve's securities holdings. To that end, the Committee began gradually raising its target range for the federal funds rate in December 2015. Later, in October 2017, it began gradually reducing holdings of Treasury and agency securities; this gradual reduction results in a decline in the supply of reserve balances. The FOMC judged that removing monetary policy stimulus through this mix of first raising the federal funds rate and then beginning to shrink the balance sheet would best contribute to achieving and maintaining maximum employment and price stability without causing dislocations in financial markets or institutions that could put the economic expansion at risk.

Interest on reserves--the payment of interest on balances held by banks in their accounts at the Federal Reserve--has been an essential policy tool that has permitted the FOMC to achieve a gradual increase in the federal funds rate in combination with a gradual reduction in the Fed's securities holdings and in the supply of reserve balances.³ Interest on reserves is a monetary policy tool used by all of the world's major central banks.

Interest on reserves is the principal tool the FOMC uses to anchor the federal funds rate in the target range. The federal funds rate, in turn, establishes an important benchmark for the borrowing and lending decisions in the banking sector (figure A). When the Federal Reserve increases the target range for the federal funds rate and the interest rate it pays on reserve balances, banks bid up the rates in short-term funding markets to levels consistent with those increases; rates in other short-term funding markets--such as commercial paper rates, Treasury bill rates, and rates on repurchase agreements--all tend to move higher as well (figure B). This increase in the general level of short-term rates, together with the expected future path of short-term rates, then influences the level of other financial asset prices and overall financial conditions in the economy. Thus, changing the interest rate on reserves has proven to be an effective tool for transmitting changes in the FOMC's target range for the federal funds rate to other interest rates in the economy.

The rate of interest the Federal Reserve pays on banks' reserve balances is far lower than the rate that banks can earn on alternative safe assets, including most U.S. government or agency securities, municipal securities, and loans to businesses and consumers.⁴ Indeed, the bank prime rate--the base rate that banks use for loans to many of their customers--is currently around 300 basis points above the level of interest on reserves. Banks continue to find lending attractive, and bank lending has been expanding at a solid pace since 2012. Households have begun to see interest rates on retail deposits rising as well. Moreover, the configuration of interest rates implies that the return the Federal Reserve earns on its holdings of securities is higher than the interest it pays on reserve balances. Each year, the Federal Reserve remits its earnings--that is, its income net of expenses--to the Treasury Department; in 2017, remittances totaled more than $80 billion.

Had the Federal Reserve not been able to pay interest on reserve balances at the same time that excess reserves in the banking system were large, it would not have been able to gradually raise the federal funds rate and other short-term interest rates while reserve balances were abundant; the FOMC would have had to take a different approach to scaling back monetary policy accommodation. This approach likely would have involved a rapid and sizable reduction in the Federal Reserve's securities holdings in order to put sufficient upward pressure on interest rates. Getting the pace of asset sales just right for achieving the Federal Reserve's objectives would have been extremely challenging. Such an approach to removing accommodation would have run the risk of disrupting financial markets, with adverse effects on the economy.

Indeed, as observed during the early summer of 2013, market reactions to changes in the outlook for the Federal Reserve's holdings of long-term securities can have outsized effects in bond markets. At that time, FOMC communications that pointed to the eventual cessation of asset purchases seemed to alarm investors and reportedly contributed to a rise in longer-term rates of 150 basis points over just a few months. That rise in rates quickly pushed up the cost of mortgage credit and rates on other forms of borrowing for households and businesses.

Thus, Federal Reserve policymakers judged that the best strategy for adjusting the stance of monetary policy would be gradual increases in the target range for the federal funds rate, supplemented later on by gradual reductions in the Federal Reserve's securities holdings. The ongoing, gradual reduction in the Federal Reserve's securities holdings that the FOMC set in motion in 2017 will bring the level of reserve balances down substantially over the next few years. The size of reserves that banks eventually want to hold will reflect balances held to meet reserve requirements and payments needs as well as balances held to address regulatory and structural changes in the banking system since the financial crisis.⁵ Although the level of reserve balances that banks will eventually want to hold is not yet known, that level is likely to be much lower than it is today, though appreciably higher than it was before the crisis.⁶ In addition, the amount of U.S. currency--Federal Reserve notes--that people in the United States and elsewhere want to hold has increased substantially since the crisis. If banks want to hold more reserve balances and the public wants to hold more U.S. currency than before the crisis, the Federal Reserve will need to supply the reserves and currency, so the Federal Reserve's securities holdings also will have to be larger than before the financial crisis.⁷

Interest on reserves will remain an important policy tool for keeping the federal funds rate within the target range set by the FOMC and thus managing the level of short-term interest rates, even as the ongoing reduction in the Federal Reserve's securities holdings generates a gradual decline in the amount of reserve balances on which the Federal Reserve pays interest. In June 2018, the Federal Reserve made a small technical adjustment to de-link the rate of interest on reserves from the top of the Committee's target range for the federal funds rate. At the June 2018 FOMC meeting, the Committee increased the federal funds target range by 25 basis points, while the rate of interest on reserve balances was increased by 20 basis points. This change is intended to ensure that the federal funds rate continues to trade well within the Committee's target range. The spread between the effective federal funds rate and the rate of interest on reserves could continue to narrow over time as the Federal Reserve's securities holdings and the supply of reserve balances gradually decline.