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 presents five policy rules—illustrative of the many rules that have received attention in the research literature—and provides examples of two ways to compute historical prescriptions of policy rules. The two ways differ in terms of whether the implications of the rule prescriptions feed through to the macroeconomy and potentially back to the policy rule prescriptions themselves. The presentation highlights the uses and limitations of each way for informing the FOMC's systematic conduct of monetary policy.

Historical Prescriptions of Policy Rules

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 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. 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 over time 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 (PCE)), while the price-level rule includes the gap between the level of prices today and the level of prices that would have been realized if inflation had been constant at 2 percent from a specified starting year.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, whereas the other rules do not make up past misses of the inflation objective.

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, 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. Similarly, the price-level rule specified in figure A 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.

Policymakers regularly examine the historical prescriptions of different policy rules to help understand the past stance of monetary policy and to inform their current policy decisions. The most straightforward way to compute such prescriptions is to use historical values for the unemployment rate and inflation, as well as estimates of the longer-run value of the interest rate and the longer-run value of the unemployment rate, in each policy rule.⁶ The policy prescriptions from the various rules based on this approach provide different prescriptions for the federal funds rate, as shown in figure B. Presented in this way, each point on the lines in the figure is a snapshot of what the policy rules would have prescribed, given the economic conditions of that time. Because there is no definitive standard for favoring one rule over another, consulting a range of rules is generally preferable to relying on any particular rule. Although almost all of the simple policy rules would have called for values for the federal funds rate that were increasing in recent years, the prescribed values vary widely across rules.

Historical Prescription of the Taylor (1993) Rule with Feedback

One key consideration in evaluating monetary policy rules based solely on historical data is that the policy prescriptions from the rules do not take into account the fact that the economy would have evolved differently if the federal funds rate had followed the alternative paths prescribed by the rules. For example, if the FOMC had followed a policy rule in the past that prescribed higher values for the federal funds rate than actually occurred, the unemployment rate would likely have been higher and inflation lower than they actually turned out to be. In turn, these different outcomes for unemployment and inflation would have fed back into the policy rule, resulting in policy prescriptions that differ from those based on the historical data and shown in figure B. Proper consideration of these feedback effects requires using an economic model, which is a mathematical representation of how economic activity, inflation, the policy interest rate, and other variables interact over time. With such a model, one can assess how inflation and the unemployment rate might have evolved if a particular policy rule had been followed over some historical period in a way that incorporates these feedback effects. Federal Reserve staff regularly use models of the U.S. economy to study how economic outcomes could have differed if monetary policy had followed various rules.

Figure C provides one illustrative example of how accounting for feedback effects can alter the prescriptions from a particular rule over a given period. The figure compares the historical prescriptions of the Taylor (1993) rule calculated without feedback—as in the earlier section—with the prescriptions from the same rule incorporating feedback effects. The rule prescriptions with feedback effects result from an empirical simulation of the FRB/US model.⁷ The simulation begins in the first quarter of 2001, a period when the prescription of the Taylor (1993) rule without feedback roughly coincides with the historical value of the federal funds rate. The three panels in the figure display the paths for the federal funds rate (top panel), the unemployment rate (middle panel), and four-quarter PCE inflation (bottom panel). The historical data are shown by the black lines. The gray dashed line in the top panel shows the historical prescription of the Taylor (1993) rule without any feedback, the same as the gray dashed line shown in figure B, and the blue dashed-and-dotted line shows the prescriptions with feedback effects. Because monetary policy affects the economy only with a delay, the paths of the unemployment rate and the inflation rate are not much different from their historical values over the first year of the simulation, despite the fact that the Taylor (1993) rule calls for much higher interest rates than actually observed over that period. By 2002, however, the higher rate path under the Taylor (1993) rule causes the economy to slow, resulting in a higher unemployment rate and lower inflation—the blue dashed-and-dotted lines in the middle and bottom panels of figure C, respectively—compared with the historical values. Consequently, the policy rate path in the simulation diverges from the rate path prescribed when feedback effects are not included. Indeed, by the middle of 2003, the value of the federal funds rate is substantially higher in the calculation without feedback effects than it is in the FRB/US model simulation that incorporates feedback from the economy. This difference highlights the limitations in assessing policy rules over history if the prescriptions from the rules are notably different from the historical policy rate path and the effects of the prescriptions of such rules for the economy are not taken into account.

While model simulations can capture the effects of policy rules on the economy and what those economic effects imply for the settings of the policy rate, there are important limitations to such exercises. Each simulation is tied to a particular economic model, and changes in the model can change the prescriptions from the given policy rule. Models are necessarily simplifications of reality, and there is no agreed-upon "best" model representation of the U.S. economy. Indeed, there is substantial diversity among the models favored by economists for this kind of analysis. Finally, in the real world, the structure of the economy changes over time, so an economic model used for studying a historical episode such as the one featured here may not be relevant for future policy considerations.

Model-based simulations with feedback add an important dimension to our understanding of the effects of policy rules. However, it is important to stress that the usefulness of such rules for obtaining and communicating current and future policy rate prescriptions is still limited by a range of practical considerations, even beyond the concerns about which specific model to use. Monetary policy rules feature only a small number of variables and thus exclude many important indicators that are consulted by policymakers. The policy rules here, for example, do not include measures of financial and credit market conditions, indicators of consumer and business sentiment, and data on expectations; these factors are often very informative for the future course of the economy. Moreover, simple policy rules do not take into account possible risks to the economic outlook, which may justify a policy response over and above what would be implied by the most likely outcomes for the economy.⁸

At its meetings in January and March of this year, the Federal Open Market Committee (FOMC) made important decisions regarding its framework for monetary policy implementation and the process of normalizing the size of its balance sheet. The issues associated with these decisions have been discussed over several FOMC meetings and have been part of an ongoing process of the Committee's deliberations.¹

After indicating in previous communications that, in the longer run, the Committee intends to operate in a regime in which it holds no more securities than necessary to implement monetary policy efficiently and effectively, the FOMC decided at its January meeting to continue to implement monetary policy in a regime with an ample supply of reserves.² Such a system, which has been in place since late 2008, does not require active management of reserves through frequent open market operations. Instead, with ample reserves in the banking system, the federal funds rate is expected to settle near the rate of interest paid on excess reserves. This system has proven to be an efficient means of controlling the policy rate and effectively transmitting the stance of policy to a wide array of other money market rates and to broader financial conditions. In the statement released after its January meeting, the FOMC also indicated that it continues to view the target range for the federal funds rate as its primary tool to adjust the stance of monetary policy. Nonetheless, the Committee is prepared to adjust the details of its plans for balance sheet normalization in light of economic and financial developments. Moreover, the Committee would be prepared to use its full range of tools, including altering the size and composition of its balance sheet, if future economic conditions were to warrant a more accommodative monetary policy than can be achieved solely by reducing the federal funds rate.

Following the March FOMC meeting, the Committee announced that it intends to conclude the reduction of its aggregate securities holdings in the System Open Market Account at the end of September 2019.³ Consistent with its decision at the March FOMC meeting, the Committee slowed balance sheet runoff in May by reducing the cap for monthly redemptions of Treasury securities from $30 billion to $15 billion (left panel of figure A). In connection with its intention to cease balance sheet runoff entirely at the end of September 2019 and consistent with its aim of holding primarily Treasury securities in the longer run, the Committee also stated that it intends to continue to allow its holdings of agency securities to decline. Therefore, beginning in October 2019, principal payments received from holdings of agency debt and agency mortgage-backed securities (MBS) will be reinvested in Treasury securities through secondary-market purchases subject to a maximum amount of $20 billion per month. Purchases of Treasury securities will initially be conducted across a range of maturities to roughly match the maturity composition of Treasury securities outstanding.⁴ Any principal payments from agency securities holdings in excess of the monthly $20 billion maximum will continue to be reinvested into agency MBS (right panel of figure A).

When the process of normalizing the size of the Federal Reserve's balance sheet concludes at the end of September, reserves will likely be somewhat above the level necessary for an efficient and effective implementation of monetary policy. If so, the Committee plans after September to keep the size of the Federal Reserve's securities holdings roughly constant for a while. During this period, reserve balances will continue to decline gradually as currency and other nonreserve liabilities increase. Once the Committee judges that reserve balances have declined to the level consistent with the efficient and effective implementation of monetary policy, the FOMC plans to resume periodic open market operations to accommodate the normal trend growth in the demand for the Federal Reserve's liabilities.⁵