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).¹

This discussion examines prescriptions from selected policy rules and considers how these prescriptions often depend on judgments and assumptions about economic variables that are inherently uncertain and may change over time. Notably, many policy rules depend on estimates of resource slack and of the longer-run neutral real interest rate, both of which are not directly observable and are estimated with a high degree of uncertainty. As a result, the policy stance that these rules prescribe—and whether that stance is appropriate in light of underlying economic conditions—is also uncertain. Such a situation cautions against mechanically following the prescriptions of any specific rule.

Policy Rules: Some Key Design Principles and Historical Prescriptions

In many 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, 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. 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 (r _t ^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.⁴ The rules feature the unemployment rate gap, measured as the difference between an estimate of the rate of unemployment that is sustainable in the longer run (u _t ^L) and the current unemployment rate; the first-difference rule includes the change in the unemployment gap rather than its level.⁵ In addition, four of the five rules include the difference between recent inflation and the FOMC's longer-run objective of 2 percent, whereas 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.⁶ The price-level rule thereby takes account of the deviation of inflation from the longer-run objective in earlier periods as well as in the current period, in contrast with the other rules that 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 effective lower bound may therefore not provide enough policy accommodation. To make up for the cumulative shortfall in accommodation, the adjusted Taylor (1993) 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 policy rate is constrained by the effective lower bound, this rule will, over time, call for more accommodation to make up for the past inflation shortfall.

Figure B shows historical prescriptions for the federal funds rate from the five rules described earlier. For each period, the figure reports the policy rates prescribed by the rules given prevailing economic conditions and estimates of u _t ^LR and r _t ^LR at the time. The prescribed values often vary widely across rules. 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.

Estimates of r _t ^LR and u _t ^LR: Uncertainty and Revisions

As already noted, the level of the neutral real interest rate and the unemployment rate that is sustainable in the longer run is not directly observable and can be estimated only imprecisely. The neutral real interest rate in the longer run is determined by structural features of the economy, including trend productivity growth, demographics, and risk-taking behavior. The unemployment rate that can be sustained in the longer run is also determined largely by nonmonetary factors, such as demographics, educational attainment, and the structure and dynamics of the labor market. These various determining factors may change over time and may not be directly measurable, hence leading to time-varying and uncertain estimates of u _t ^L and r _t ^L.

Since 2000, forecasters in the Blue Chip survey have markedly reduced their estimates of the longer-run level of the real short-term interest rate (figure C). FOMC participants have also lowered their estimates of the real federal funds rate in the longer run since the Summary of Economic Projections, or SEP, began reporting this information in 2012. Similarly, in recent years, FOMC participants as well as outside forecasters and analysts generally have lowered their estimates of the longer-run unemployment rate considerably.⁷

Figure D illustrates the imprecision with which the longer-run neutral real interest rate is estimated by reporting values from several time-series models, along with measures of the uncertainty surrounding these values.⁸ The models use statistical techniques to capture the variations among inflation, interest rates, real gross domestic product, unemployment, and other data series. The point estimates are dispersed across models, ranging from 0.3 to 2.1 percent. Moreover, the 95 percent uncertainty bands around the estimates illustrate the substantial uncertainty inherent in such estimates.⁹

D. Point estimates and uncertainty bands for the neutral real interest rate in the longer run

Some Implications for Monetary Policy

The longer-run neutral level of the federal funds rate—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 estimates of the longer-run neutral real interest rate leads to uncertainty about how far the current federal funds rate is from its longer-run neutral level. For the Taylor (1993), balanced-approach, adjusted Taylor (1993), and price-level rules, a decrease in the assumed longer-run neutral real interest rate translates one-for-one into a decline in these rules' prescribed settings for the federal funds rate. Therefore, to the extent that the downward revisions to estimates of r _t ^L reflect learning that the longer-run neutral rate was lower than had been assessed previously, the historical prescriptions of these rules would be less accommodative than previously thought. Uncertainty about estimates of the longer-run normal unemployment rate also imparts uncertainty to these rules' prescriptions. For example, given current economic conditions, the assumption of a lower sustainable rate of unemployment in the longer run translates one-for-one into reduced unemployment gaps in the rules and, in turn, leads to lower prescribed values of the policy rate.

Figure E compares the prescriptions of the Taylor (1993) rule based on the historical median estimates of u _t ^L and r _t ^L from the Blue Chip survey (shown in figure C) and the prescriptions generated based on the latest median estimates of these variables. The federal funds rate prescriptions based on the latest estimates (black line) are lower than the prescriptions based on the historical estimates (red line). For example, using the latest median estimates, the rule's prescribed federal funds rates for 2012 are about 3 percentage points lower than the values prescribed based on the historical estimates. Figure E also shows that revisions to the estimates of u _t ^L and r _t ^L contribute roughly equally to the difference in the policy rate prescriptions of the Taylor (1993) rule based on the historical and the latest estimates of u _t ^L and r _t ^L.¹⁰

To conclude, this discussion illustrates that policy rules crucially entail an important element of judgment. Moreover, the inherent uncertainty about some of the variables included in these rules leads to significant uncertainty regarding their policy settings, which cautions against strict adherence to any particular rule.

Consistent with its decision at the January 2019 meeting, the Federal Open Market Committee (FOMC) reaffirmed, in its Statement Regarding Monetary Policy Implementation on October 11, 2019, the intention to implement monetary policy in a regime with an ample supply of reserves.¹ In such a system, active management of reserves through frequent open market operations is not required, and control over the level of the federal funds rate and other short-term interest rates is exercised primarily through the setting of the Federal Reserve's administered rates.

In recent years, depository institutions' reserve balances held at the Federal Reserve have declined as a result of the normalization of the Federal Reserve's balance sheet as well as growth in nonreserve liabilities. Reserves dropped from a peak of about $2.8 trillion in 2014 to about $2.2 trillion in late September 2017, largely reflecting the expansion of nonreserve liabilities. Subsequently, reserves declined further, reflecting the FOMC's decision to allow a gradual runoff of maturing securities, and, by the time the FOMC decided to conclude the reduction of its aggregate securities holdings in August 2019, reserves had fallen to about $1.5 trillion. Despite the cessation of balance sheet runoff in August 2019, reserves subsequently continued to decline because of increases in currency and other nonreserve liabilities and reached a multiyear low of about $1.4 trillion in September 2019.

Against a backdrop of declining reserves and high levels of Treasury securities outstanding, in mid-September 2019, imbalances in the supply of and demand for short-term funding led to pressures in the repurchase agreement (repo) market—a money market segment in which banks, securities dealers, money market funds (MMFs), and other financial market participants lend to and borrow from each other for short periods against high-quality collateral. On the demand side, dealers' and other investors' needs for financing securities had increased following the settlement of Treasury auctions at mid-month. On the supply side, some institutional investors, such as government-only MMFs and banks, may have been reluctant to increase lending because they faced uncertainty regarding cash outflows as their clients were making corporate tax payments due in mid-September. As a result, repo rates rose sharply in mid-September (figure A). Pressures in the repo market spilled over to other short-term funding markets, including the federal funds market. The federal funds rate firmed, moving out of its target range for one day (as shown in figure A). In response to elevated rates, the Federal Reserve began conducting repo operations to help stabilize money markets and provide reserves to keep the federal funds rate within its target range (figure B). These operations have been effective in meeting these goals.

Consistent with its decision to implement monetary policy in a regime with an ample supply of reserves, on October 11, 2019, the Committee announced its decision to purchase Treasury bills at least into the second quarter of 2020 in order to maintain reserves at or above the level that prevailed in early September (as shown in figure B).² In addition, the FOMC announced term and overnight repo operations to ensure that the supply of reserves remains ample even during periods of sharp increases in nonreserve liabilities and to mitigate the risk of money market pressures that could adversely affect policy implementation.³ Repos outstanding, consisting of both overnight and term operations, have been about $209 billion per day, on average, since the announcement on October 11, 2019. These operations are expected to decline over time as Treasury bill purchases supply a larger base of reserves.

The Federal Reserve's open market operations—repo operations and bill purchases—lifted reserves to levels averaging about $1.6 trillion in early 2020. Besides adding reserves, the repo operations damped funding pressures in repo markets that may otherwise have passed through to the federal funds market. As such, the combination of repo operations and bill purchases fostered conditions that helped maintain the federal funds rate within the target range. Notably, with the provision of about $250 billion in liquidity via the Federal Reserve's repo operations, money market conditions were quite calm on year-end. Both secured and unsecured overnight funding rates printed in line with the interest rate on excess reserves (as indicated in figure A).

Overview

In 2019, the Federal Reserve began a broad review of the monetary policy strategy, tools, and communication practices it uses to pursue its statutory dual-mandate goals of maximum employment and price stability. The Federal Reserve is undertaking the review because the U.S. economy appears to have changed in ways that matter for 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 the effective lower bound on interest rates will constrain central banks from reducing their policy interest rates enough to effectively support economic activity during downturns. The review is considering what monetary policy strategy will best enable the Federal Reserve to meet its dual mandate in the future, whether the existing monetary policy tools are sufficient to achieve and maintain the dual mandate, and how its communication about monetary policy can be improved.

Fed Listens Initiative

A key component of the review has been a series of public Fed Listens events aimed at consulting with a broad range of stakeholders in the U.S. economy. The goal of Fed Listens was for policymakers to engage directly with a range of individuals and groups on issues pertaining to the dual-mandate objectives of maximum employment and stable prices.

From February to October 2019, the Federal Reserve hosted 14 public Fed Listens events—one at the Board of Governors, one at each of the 12 Reserve Banks, and a System research conference at the Federal Reserve Bank of Chicago. The events featured a broad range of participants drawn from the System's existing advisory councils and community networks and from outreach conducted specifically for the Fed Listens initiative. The participants represented small businesses, labor unions, state and local governments, schools and community colleges, workforce development organizations, housing groups, community development financial institutions (CDFIs), retirees, and academia.

Most of the events were conducted in a town hall format with one or more panel sessions. A few incorporated site visits to schools and businesses to learn about local initiatives in underserved communities to increase education, combine high school completion with work experience, or offer after-hours vocational training to enhance skill levels.

At the events, participants were asked how they viewed the relative importance of maximum employment and price stability and how monetary policy actions affected them and the people they represent. Participants commented on labor market conditions and whether they saw those conditions as consistent with the dual-mandate objective of maximum employment; they also offered perspectives on inflation, lending conditions, and how people in their organizations or communities responded to interest rate changes. In addition, participants often compared economic conditions today with conditions a few years or a decade ago and assessed the Federal Reserve's public communications. In keeping with the transparency of the review, all of the events were livestreamed, with written summaries of the events posted on System websites afterward.¹

Takeaways from Fed Listens

While the Fed Listens events covered a broad range of topics, participants consistently highlighted a few points. Representatives of disadvantaged communities generally saw the strong labor market as providing significant benefits to their constituents—primarily by providing job opportunities for people who had had difficulty finding jobs in the past. These representatives also expressed concern about how newly hired workers would fare in the next downturn and whether the job experience they will have acquired by then would allow them to retain their jobs during the downturn or obtain jobs easily after the economy recovers.

Small business owners and representatives from business organizations said finding qualified workers to fill available positions was a challenge in the current labor market conditions. As a result, businesses are partnering with workforce development agencies or community colleges to devise training programs or specialized curriculums to prepare would-be workers. In addition, firms have been more willing to hire people who would not have been considered in less favorable labor market conditions. However, businesses generally are not increasing wages to attract and retain workers. Instead, they are offering new training or education programs and adding or augmenting health-care and other benefits.

While businesses and CDFIs generally found low interest rates to be beneficial, representatives of underserved populations and retirees conveyed different views. Many people in lower-income communities generally have little or no access to conventional credit. Consequently, they often do not benefit when interest rates on conventional credit fall as a result of the Fed's actions. In addition, we heard that retirees with savings have seen interest income on their savings decline.

Participants acknowledged that inflation is low, and representatives of small businesses or business associations emphasized the importance of stable and predictable inflation for planning and decisionmaking. Participants representing retirees said rising costs of health care and prescription drugs pose challenges for people on fixed incomes, while representatives of low- and middle-income communities said the people they represent still struggle to afford basic necessities such as housing, utilities, and food. Participants generally did not regard the fact that aggregate inflation is running modestly below the Federal Reserve's 2 percent objective as a problem. That perception highlights a challenge for the Federal Reserve as it publicly communicates about the rationale for the review and the importance of anchoring inflation expectations at 2 percent for keeping policy interest rates sufficiently above the effective lower bound.

Policymaker Discussions

Since the summer of 2019, Federal Reserve policymakers have been discussing issues associated with the monetary policy strategy review at meetings of the Federal Open Market Committee (FOMC). At its July, September, and October meetings, the FOMC reviewed the performance of its current approach to monetary policy, discussed possible alternative policy strategies, and reviewed policy tools. Key points of these discussions have been summarized in publicly released meeting minutes. In December, the FOMC considered the views offered at the Fed Listens events together with staff analysis on the distributional effects of monetary policy. The FOMC's discussions are continuing into 2020. Policymakers expect to complete the review around the middle of this year. At that time, policymakers will report their findings to the public.