Board of Governors of the Federal Reserve System

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 and a measure of resource slack in the economy. The prescriptions for the policy interest rate from these rules can provide helpful guidance for the Federal Open Market Committee (FOMC). This discussion provides information on how policy rules inform the FOMC's systematic conduct of monetary policy, as well as practical considerations that make it undesirable for the FOMC to mechanically follow the prescriptions of any specific rule. The FOMC's approach for conducting monetary policy provides sufficient flexibility to address the intrinsic complexities and uncertainties in the economy while keeping monetary policy predictable and transparent.

Policy Rules and Historical Prescriptions

The effectiveness of monetary policy is enhanced when it is well understood by the public.¹ In simple models of the economy, good economic performance can be achieved by following a specific monetary policy rule that fosters public understanding and that incorporates key principles of good monetary policy.² One such principle is that monetary policy should respond in a predictable way to changes in economic conditions and the economic outlook. A second principle is that monetary policy should be accommodative when inflation is below policymakers' longer-run inflation objective and employment is below its maximum sustainable level; conversely, monetary policy should be restrictive when the opposite holds. A third 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).³ These policy rules embody the three key principles of good monetary policy and take into account estimates of how far the economy is from 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.⁴ 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 ( PLgapt).⁵ 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.

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 the federal funds rate has fallen to its lower bound may therefore not provide enough policy accommodation. To make up for the cumulative shortfall in accommodation Zt, 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 version of the 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 price-level rule prescribes setting the federal funds rate well below zero, the rule will, over time, call for more accommodation to make up for the past inflation shortfall.

As shown in figure B, the different monetary policy rules often differ in their prescriptions for the federal funds rate.⁶ Although almost all of the simple policy rules would have called for values for the federal funds rate that were increasing over time in recent years, the prescribed values vary widely across rules. In general, there is no unique criterion for favoring one rule over another.

Systematic Monetary Policy in Practice

Although monetary policy rules seem appealing for obtaining and communicating current and future policy rate prescriptions, the usefulness of these rules for policymakers is limited by a range of practical considerations. According to simple monetary policy rules, the policy interest rate must respond mechanically to a small number of variables. However, these variables may not reflect important information available to policymakers at the time they make decisions. For example, none of the inputs into the Taylor (1993) rule include financial and credit market conditions or indicators of consumer and business sentiment; these factors are often very informative for the future course of the economy. Similarly, monetary policy rules tend to include only the current values of the selected variables in the rule. But the relationship between the current values of these variables and the outlook for the economy changes over time for a number of reasons. For example, the structure of the economy is evolving over time and is not known with certainty at any given point in time.⁷ To complicate matters further, monetary policy affects the Federal Reserve's goal variables of inflation and employment with long and variable lags. For these reasons, good monetary policy must take into account the information contained in the real-time forecast of the economy. Finally, simple policy rules do not take into account that the risks to the economic outlook may be asymmetric, such as during the period when the federal funds rate was still close to zero. At that time, the FOMC took into consideration that it would have limited scope to respond to an unexpected weakening in the economy by cutting the federal funds rate, but that it would have ample scope to increase the policy rate in response to an unexpected strengthening in the economy. This asymmetric risk provided a rationale for increasing the federal funds rate more gradually than prescribed by some policy rules shown in figure B.⁸

The FOMC conducts systematic monetary policy in a framework that respects the key principles of good monetary policy while providing sufficient flexibility to address many of the practical concerns described earlier. At the core of this framework lies the FOMC's firm commitment to the Federal Reserve's statutory mandate of promoting maximum employment and price stability, a commitment that the Committee reaffirms on a regular basis.⁹ To explain its monetary policy decisions to the public as clearly as possible, the FOMC communicates about the economic data that are relevant to its policy decisions. As part of this communication strategy, the Federal Reserve regularly describes the economic and financial data used to inform its policy decisions in the Monetary Policy Report and the FOMC meeting minutes. These data include, but are not limited to, measures of labor market conditions, inflation, household spending and business investment, asset prices, and the global economic environment. The FOMC postmeeting statements and the meeting minutes detail how the data inform the Committee's overall economic outlook, the risks to this outlook, and, in turn, the Committee's assessment about the appropriate stance of monetary policy. This appropriate stance depends on the FOMC's longer-run goals, the economic outlook and the risks to the outlook, and the channels through which monetary policy actions influence economic activity and prices. The FOMC combines all of these elements in determining the timing and size of adjustments of the policy interest rates. The quarterly Summary of Economic Projections provides additional information about each FOMC participant's forecasts for the economy and the longer-run assessments of the economy, under her or his individual views concerning appropriate policy.

These policy communications help the public understand the FOMC's approach to monetary policymaking and the principles that underlie it. Consequently, in response to incoming information, market participants tend to adjust their expectations regarding monetary policy in the direction consistent with achieving the maximum-employment and price-stability goals of the FOMC.¹⁰ Evidence that market participants adjust their expectations for policy in this manner is shown in figure C. The figure plots the change in the 10-year yield on Treasury securities in a one-hour window around the release of employment reports on the vertical axis against the difference in the actual value of nonfarm payroll job gains and the expectations of private-sector analysts immediately before the release of the data on the horizontal axis--that is, a proxy for "surprises" in nonfarm payroll job gains. When actual nonfarm payroll job gains turn out to be higher than market participants expect, the yield on 10-year Treasury securities tends to increase. The rise in the 10-year yield reflects market participants' expectation that, as a result of stronger-than-expected labor market data, the path of short-term interest rates will be higher in the future. Conversely, the 10-year yield tends to decline after negative surprises in nonfarm payroll data, reflecting the path of short-term interest rates will be somewhat lower in the future. These adjustments in the 10-year yield help stabilize the economy even before the FOMC changes the level of the federal funds rate in the direction consistent with achieving its goals, as higher long-term interest rates tend to slow the labor market while lower rates tend to strengthen it.

The size of the Federal Reserve's balance sheet increased from $900 billion at the end of 2006 to about $4.5 trillion at the end of 2014--or from 6 percent of gross domestic product (GDP) to about 25 percent of GDP--mainly as a result of the large-scale asset purchase (LSAP) programs conducted in response to persistent economic weakness following the financial crisis. The expansion of total assets that stemmed from the LSAPs was primarily matched by higher reserve balances of depository institutions, which peaked in the fall of 2014 at $2.8 trillion, or almost 16 percent of GDP, rising from about $10 billion at the end of 2006. Liabilities other than reserves have also grown significantly and played a role in the expansion of the balance sheet. The magnitude of these nonreserve liabilities as well as the flows affecting their variability are not closely related to monetary policy decisions. Since October 2017, the Federal Reserve has been gradually reducing its securities holdings resulting from crisis-era purchases. Once these holdings have unwound to the point at which reserve balances have declined to their longer-run level, the size of the balance sheet will be determined by factors affecting the demand for Federal Reserve liabilities. This discussion describes the Federal Reserve's most significant liabilities and reviews the factors that influenced their size since the financial crisis. Many of the Federal Reserve's liabilities arise from statutory responsibilities, such as supplying currency and serving as the Treasury Department's fiscal agent. Each liability provides social benefits to the economy and plays an important role as a safe and liquid asset for the public, the banking system, the U.S. government, or other institutions.

Figure A plots the evolution of the Federal Reserve's main liabilities relative to nominal GDP over the post-World War II period. Federal Reserve notes outstanding have traditionally been the largest Federal Reserve liability and, over the past three decades, have been slowly growing as a share of U.S. nominal GDP. U.S. currency is an important medium of exchange and store of value, both domestically and abroad. Despite the increasing use of electronic means of payment, currency remains widely used in retail transactions in the United States. Demand for currency tends to increase with the size of the economy because households and businesses need more currency to use in exchange for a growing volume of economic transactions. In addition, with heavy usage of U.S. currency overseas, changes in global growth as well as in financial and geopolitical stability can also materially affect the rate of currency growth. Since the start of the Global Financial Crisis, notes in circulation have more than doubled and, as of the end of 2018, stood at about $1.67 trillion, equivalent to about 8 percent of U.S. GDP, implying that accommodating demand for currency alone requires a larger balance sheet than before the crisis.

Reserve balances are currently the second-largest liability in the Federal Reserve's balance sheet, totaling $1.66 trillion at the end of 2018, or nearly 8 percent of nominal GDP. This liability item consists of deposits held at Federal Reserve Banks by depository institutions, including commercial banks, savings banks, credit unions, thrift institutions, and most U.S. branches and agencies of foreign banks. These balances include reserves held to fulfill reserve requirements as well as reserves held in excess of these requirements. Reserve balances allow banks to facilitate daily payment flows, both in ordinary times and in stress scenarios, without borrowing funds or selling assets. Reserve balances have been declining for several years, in part as a result of the ongoing balance sheet normalization program initiated in October 2017, and now stand about $1.2 trillion below their peak in 2014. At its January 2019 meeting, the Federal Open Market Committee decided that it would continue to implement monetary policy in a regime with an ample supply of reserves, which is often called a "floor system" or an "abundant reserves system." ¹ Going forward, the banking system's overall demand for reserve balances and the Committee's judgment about the quantity that is appropriate for the efficient and effective implementation of monetary policy will determine the longer-run level of reserve balances. Although the level of reserve balances that banks will eventually demand is not yet known with certainty, it is likely to be appreciably higher than before the crisis. Banks' higher demand for reserves appears to reflect in part an increased focus on liquidity risk management in the context of regulatory changes.

Liabilities other than currency and reserves include the Treasury General Account (TGA), reverse repurchase agreements conducted with foreign official account holders, and deposits held by designated financial market utilities (DFMUs). By statute, the Federal Reserve serves a special role as fiscal agent or banker for the federal government. Consequently, the U.S. Treasury holds cash balances at the Federal Reserve in the TGA, using this account to receive taxes and proceeds of securities sales and to pay the government's bills, including interest and principal on maturing securities. Before 2008, the Treasury targeted a steady, low balance of $5 billion in the TGA on most days, and it used private accounts at commercial banks to manage the variability in its cash flows. Since 2008, the Treasury has used the TGA as the primary account for managing cash flows. In May 2015, the Treasury announced its intention to hold in the TGA a level of cash generally sufficient to cover one week of outflows, subject to a minimum balance objective of roughly $150 billion. Since this policy change, the TGA balance has generally been well above this minimum; at the end of 2018, it was about $370 billion, or nearly 2 percent of GDP. The current policy helps protect against the risk that extreme weather or other technical or operational events might cause an interruption in access to debt markets and leave the Treasury unable to fund U.S. government operations--a scenario that could have serious consequences for financial stability.

Reverse repurchase agreements with foreign official accounts, also known as the foreign repo pool, also rose during recent years. The Federal Reserve has long offered this service as part of a suite of banking and custody services to foreign central banks, foreign governments, and international official institutions. Accounts at the Federal Reserve provide foreign official institutions with access to immediate dollar liquidity to support operational needs, to clear and settle securities in their accounts, and to address unexpected dollar shortages or exchange rate volatility. The foreign repo pool has grown from an average level of around $30 billion before the crisis to a current average of about $250 billion, equivalent to a little more than 1 percent of GDP. The rise in foreign repo pool balances has reflected in part central banks' preference to maintain robust dollar liquidity buffers.

Finally, "other deposits" with the Federal Reserve Banks have also risen steadily over recent years, from less than $1 billion before the crisis to about $80 billion at the end of 2018. Although "other deposits" include balances held by international and multilateral organizations, government-sponsored enterprises, and other miscellaneous items, the increase has largely been driven by the establishments of accounts for DFMUs. DFMUs provide the infrastructure for transferring, clearing, and settling payments, securities, and other transactions among financial institutions. The Dodd-Frank Wall Street Reform and Consumer Protection Act provides that DFMUs--those financial market utilities designated as systemically important by the Financial Stability Oversight Council--can maintain accounts at the Federal Reserve and earn interest on balances maintained in those accounts.

Putting together all of these elements--that is, projected trend growth for currency in circulation, the Committee's decision to continue operating with ample reserves, and the higher levels for the TGA, the foreign repo pool, and DFMU balances--explains why the longer-run size of the Federal Reserve's balance sheet will be considerably larger than before the crisis. At the end of 2018, the Federal Reserve's balance sheet totaled $4.1 trillion, or about 20 percent of GDP. Figure B considers the size of the balance sheet in an international context. In response to the Global Financial Crisis, central bank balance sheets increased in many jurisdictions. Relative to GDP, the Federal Reserve's balance sheet remains smaller than those of other reserve-currency central banks in major advanced foreign economies that currently operate with abundant reserves--such as the European Central Bank, the Bank of Japan, and the Bank of England--although this difference is partly due to the Federal Reserve being much further along in the policy normalization process after the crisis. In addition, the Federal Reserve's balance sheet relative to GDP is only modestly larger than those of central banks, such as the Norges Bank and the Reserve Bank of New Zealand, that aim to operate at a relatively low level of abundant reserves. Of course, differences in central bank balance sheets also reflect differences in financial systems across countries.

Over the past 25 years, the Federal Reserve and other major central banks have taken steps to improve transparency, which provides three important benefits. First, transparency helps ensure that central banks are held accountable to the public and its elected representatives. Accountability is essential to democratic legitimacy and is particularly important for central banks that have been granted extensive operational independence, as is the case for the Federal Reserve. Second, transparency enhances the effectiveness of monetary policy. If the public understands the central bank's views on the economy and monetary policy, then households and businesses will take those views into account in making their spending and investment plans. Third, transparency supports a central bank's efforts to promote the safety and soundness of financial institutions and the overall financial system, including by helping financial institutions know what is expected of them. Thus, for each of these reasons, the Federal Reserve seeks to explain its policymaking approach and decisions to the Congress and the public as clearly as possible.

To foster transparency and accountability, the Federal Reserve uses a wide variety of communications, including semiannual testimony by the Chairman in conjunction with this report, the Monetary Policy Report. In addition, the Federal Open Market Committee (FOMC) has released a statement after every regularly scheduled meeting for almost 20 years, and detailed minutes of FOMC meetings have been released since 1993.¹ In 2007, the Federal Reserve expanded the economic projections that have accompanied the Monetary Policy Report since 1979 into the Summary of Economic Projections, which FOMC participants submit every quarter. And in 2012, the FOMC first released its Statement on Longer-Run Goals and Monetary Policy Strategy, which it reaffirms annually.²

The Federal Reserve continues to make improvements to its communications. In January, the Chairman began holding a press conference after each FOMC meeting, doubling the frequency of the press conferences that were introduced in 2011. These press conferences are held 30 minutes after the release of the postmeeting statement and provide additional information about the economic outlook, the Committee's policy decision, and policy tools. Press conferences also allow the Chairman to answer questions on monetary policy and other issues in a timely fashion.

In November 2018, the Federal Reserve announced that it would conduct a broad review of its monetary policy framework--specifically, of the policy strategy, tools, and communication practices that the FOMC uses in the pursuit of its dual-mandate goals of maximum employment and price stability. The Federal Reserve's existing policy framework is the result of decades of learning and refinements and has allowed the FOMC to pursue effectively its dual-mandate goals. Central banks in a number of other advanced economies have also found it useful, at times, to conduct reviews of their monetary policy frameworks. Such a review seems particularly appropriate when the economy appears to have changed in ways that matter for the conduct of monetary policy. For example, the neutral level of the policy interest rate appears to have fallen in the United States and abroad, increasing the risk that a central bank's policy rate will be constrained by its effective lower bound in future economic downturns. The review will consider ways to ensure that the Federal Reserve's monetary policy strategy, tools, and communications going forward provide the best means to achieve and maintain the dual-mandate objectives.

The review will include outreach to and consultation with a broad range of stakeholders in the U.S. economy through a series of "Fed Listens" events. The Reserve Banks will hold forums around the country, in a town hall format, allowing the Federal Reserve to gather perspectives from the public, including representatives of business and industry, labor leaders, community and economic development officials, academics, nonprofit organizations, community bankers, local government officials, and representatives of congressional offices in Reserve Bank Districts.³ In addition, the Federal Reserve System will sponsor a research conference this June at the Federal Reserve Bank of Chicago, with academic speakers and non-academic panelists from outside the Federal Reserve System.

Beginning around the middle of 2019, as part of their review of how to best pursue the Fed's statutory mandate, Federal Reserve policymakers will discuss relevant economic research as well as the perspectives offered during the outreach events. At the end of the process, policymakers will assess the information and perspectives gathered and will report their findings and conclusions to the public.

This review complements other recent changes to the Federal Reserve's communication practices. In November 2018, the Board inaugurated two reports, the Supervision and Regulation Report and the Financial Stability Report. ⁴ These reports provide information about the Board's responsibility, shared with other government agencies, to foster the safety and soundness of the U.S. banking system and to promote financial stability. Transparency is key to these efforts, as it enhances public confidence, allows for the consideration of outside ideas, and makes it easier for regulated entities to know what is expected of them and how best to comply.

The Supervision and Regulation Report provides an overview of banking conditions and the current areas of focus of the Federal Reserve's regulatory policy framework, including pending rules, and key themes, trends, and priorities regarding supervisory programs. The report distinguishes between large financial institutions and regional and community banking organizations because supervisory approaches and priorities for these institutions frequently differ. The report provides information to the public in conjunction with semiannual testimony before the Congress by the Vice Chairman for Supervision.

The Financial Stability Report summarizes the Board's monitoring of vulnerabilities in the financial system. The Board monitors four broad categories of vulnerabilities, including elevated valuation pressures (as signaled by asset prices that are high relative to economic fundamentals or historical norms), excessive borrowing by businesses and households, excessive leverage within the financial sector, and funding risks (risks associated with a withdrawal of funds from a particular financial institution or sector, for example as part of a "financial panic"). Assessments of these vulnerabilities inform Federal Reserve actions to promote the resilience of the financial system, including through its supervision and regulation of financial institutions.

Through all of these efforts to improve its communications, the Federal Reserve seeks to enhance transparency and accountability regarding how it pursues its statutory responsibilities.