Board of Governors of the Federal Reserve System

Simple interest rate rules 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. Policymakers consult prescriptions of the policy interest rate derived from a variety of policy rules for guidance, without mechanically following the prescriptions of any particular rule. This discussion examines the prescriptions of a number of interest rate rules. One simplification these rules typically adopt is ignoring the effective lower bound (ELB) on interest rates, and many of the rules have prescribed negative values for the federal funds rate since the onset of the pandemic-driven recession.

Most rules analyzed in the research literature respond to deviations—both positive and negative—of resource utilization from its trend level because they were informed by historical periods and economic models in which high resource utilization is accompanied by inflation pressure. By contrast, the Federal Open Market Committee's (FOMC) Statement on Longer-Run Goals and Monetary Policy Strategy indicates that policymakers would not respond to high employment unless it was accompanied by signs of unwanted increases in inflation or the emergence of other risks that could impede the attainment of the Committee's goals.¹ Accordingly, this discussion examines—in addition to the prescriptions of a number of commonly studied monetary policy rules—the prescriptions of a modified simple rule that, all else being equal, does not mechanically call for policy rate increases as unemployment drops below its estimated longer-run level.²

Policy Rules: Some Key Design Principles and Limitations

In many stylized models of the economy, desirable economic outcomes can be achieved by following a monetary policy rule that incorporates key principles of good monetary policy. One such principle is that monetary policy should respond in a predictable way to changes in economic conditions, thus fostering public understanding of policymakers' goals and strategy. A second principle is that, to stabilize inflation, the policy rate should be adjusted over time in response to persistent increases or decreases in inflation to an extent sufficient to ensure a return of inflation to the central bank's longer-run objective.

Simple monetary policy rules also have important limitations. As noted earlier, simple rules do not typically recognize that the ELB limits the extent to which the policy rate can be lowered to support the economy, which may impart a downward bias to both employment and inflation. To mitigate the challenges posed by the ELB and anchor longer-term inflation expectations at 2 percent, the Committee indicates in its statement that it "seeks to achieve inflation that averages 2 percent over time, and therefore judges that, following periods when inflation has been running persistently below 2 percent, appropriate monetary policy will likely aim to achieve inflation moderately above 2 percent for some time."³ None of the simple rules analyzed in this discussion include any mechanism to offset the downward bias in inflation imposed by the ELB. As such, they do not reflect these important aspects of the FOMC's monetary policy strategy.

Another limitation is that simple rules respond to only a small set of economic variables and thus necessarily abstract from many of the considerations that the FOMC takes into account. For example, a simple rule might respond to movements in a specific labor market indicator, such as the overall unemployment rate. However, no single labor market indicator can precisely capture the size of the shortfall from maximum employment or identify when a strong labor market can be sustained without putting undue upward pressure on inflation; many labor market indicators must be assessed.⁴ Similarly, simple policy rules that systematically call for increases in the policy rate as slack in the labor market diminishes might fail to recognize the benefits of sustaining a strong labor market.⁵

Finally, simple rules for the policy rate do not explicitly recognize that the monetary policy toolkit includes other tools—notably, large-scale asset purchases and forward guidance, which are especially relevant when the policy rate is constrained by the ELB. (See the box "Developments in the Federal Reserve's Balance Sheet and Money Markets.")

Policy Rules: Descriptions

Economists have analyzed many monetary policy rules, including the well-known Taylor (1993) rule, the "balanced approach" rule, the "adjusted Taylor (1993)" rule, and the "first difference" rule.⁶ In addition to these rules, figure A shows a "balanced approach (shortfalls)" rule, which represents one simple way to illustrate the Committee's focus on shortfalls from maximum employment. All of the policy rules analyzed in this discussion embody the key principles of good monetary policy previously noted as well as the important limitations.

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All five rules feature the unemployment rate gap, measured as the difference between an estimate of the rate of unemployment in the longer run ($$ u_t^{LR}$$) and the current unemployment rate; the first-difference rule includes the change in the unemployment rate gap rather than its level.⁷ All of the rules abstract from the uncertainty that surrounds estimates of the unemployment rate gap. In addition, all of the rules include the difference between inflation and the FOMC's longer-run objective of 2 percent.⁸ All but the first-difference rule include an estimate of the neutral real interest rate in the longer run ($$ r_t^{LR}$$).⁹

By construction, the balanced-approach (shortfalls) rule prescribes identical policy rates to those prescribed by the balanced-approach rule at times when the unemployment rate is above its estimated longer-run level. However, when the unemployment rate is below that level, the balanced-approach (shortfalls) rule is more accommodative than the balanced-approach rule because it does not call for the policy rate to rise as the unemployment rate drops further.

Unlike the other simple rules featured here, the adjusted Taylor (1993) rule recognizes that the federal funds rate cannot be reduced materially below the ELB. To make up for the cumulative shortfall in accommodation following a recession during which the federal funds rate has fallen to its ELB, the adjusted Taylor (1993) rule prescribes delaying the return of the policy rate to the (positive) levels prescribed by the standard Taylor (1993) rule until after the economy begins to recover.

Policy Rules: Prescriptions

Figure B shows historical prescriptions for the federal funds rate from the five rules. For each period, the figure reports the policy rates prescribed by the rules, taking as given the prevailing economic conditions and estimates of $$ u_t^{LR}$$ and $$ r_t^{LR}$$ at the time. The four rules whose formulas do not impose a lower bound on the value of the federal funds rate imply prescriptions of strongly negative policy rates in response to the pandemic-driven recession, well below their respective troughs in the 2008–09 recession. The prescriptions of the balanced-approach and balanced-approach (shortfalls) rules are the most negative because these rules call for relatively large responses to resource slack. The negative prescriptions of the four rules show the extent to which policymakers' ability to support the economy through reductions in the federal funds rate has been constrained by the ELB during the pandemic-driven recession—a constraint that underlines the importance of the FOMC's other policy actions at the time, including forward guidance about the federal funds rate and large-scale asset purchases.

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Regarding the recovery from the 2008–09 recession, all of the simple rules shown here prescribed departure from the ELB well before the FOMC determined that it was appropriate to raise the federal funds rate. The FOMC judged, on the basis of a wide range of information available at the time, that it was appropriate to maintain a more accommodative path of the federal funds rate than prescribed by these rules. Similarly, in the aftermath of the pandemic-driven recession, the FOMC has been drawing from a broad range of indicators, analyses, and judgments in making its determinations concerning the appropriate stance for monetary policy, including readings on public health, labor market conditions, inflation pressures and inflation expectations, and financial and international developments. Under the FOMC's flexible form of average inflation targeting, departure from the ELB might be delayed relative to the simple rules by the desire to see inflation run moderately above 2 percent for some time. While the simple rules are concerned with period-by-period inflation, the Committee aims for a sustained return of inflation to the 2 percent objective.

The Federal Reserve's asset purchases since March 2020 have resulted in a large and rapid expansion of the Federal Reserve's balance sheet. Federal Reserve assets totaled $4.2 trillion before the pandemic in January 2020 and have since grown to $8.1 trillion (figure A). As net asset purchases proceed at a pace of $120 billion per month, the Federal Reserve's total liabilities increase correspondingly.¹ Alongside this growth in aggregate liabilities arising from asset purchases, there have also been large compositional shifts between liabilities this year due to factors that are not directly related to monetary policy decisions (figure B). This discussion reviews recent developments in the Federal Reserve's balance sheet and associated changes in money market conditions.

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*Note: On July 14, 2021, the “Federal Reserve notes” and “Other liabilities and capital” data were corrected to place Federal Reserve bank holdings of Federal Reserve notes in the latter category.

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Reserve balances are the largest liability on the Federal Reserve's balance sheet. Federal Reserve asset purchases are settled by adding reserves to the banking system; thus, the magnitude of asset purchases since the onset of the pandemic has brought reserves to record levels.² Reserves grew substantially earlier this year, from $3.1 trillion in early January to $3.9 trillion by early April. The level of reserves was, however, mostly stable from April to June 2021, reflecting growth in other liabilities such as the overnight reverse repurchase agreement (ON RRP) facility.

In light of the Federal Reserve's role as fiscal agent for the federal government, the U.S. Treasury holds balances in the Treasury General Account (TGA), which is another liability on the Federal Reserve's balance sheet. Changes in the TGA affect other Federal Reserve liabilities such as reserves and may have implications for money market conditions. A reduction in the TGA increases the level of reserves, other things being equal, as the Treasury makes payments to individuals and businesses, which may increase private deposits in the banking system. An important recent development in this regard has been the substantial drawdown of the TGA over the first half of 2021. With the enactment of pandemic-related fiscal stimulus measures through multiple rounds of federal legislation in 2020 and 2021, the Treasury's balance in the TGA increased to unprecedentedly high levels. As shown in figure C, as the bulk of the most recent fiscal stimulus payments and tax refunds came to an end, the Treasury lowered its outstanding balance in the TGA from about $1.6 trillion at the end of January 2020 to about $850 billion by the end of June 2021. As the Treasury sought to reduce its TGA balance, the Treasury also lowered its net issuance of Treasury bills substantially in 2021.

C. Balance sheet comparison*

The developments with reserves, the TGA, and Treasury bill issuance have affected money markets in 2021. The recent large increases in reserves, resulting from both asset purchases and reductions in the TGA, have put broad but modest downward pressure on short-term interest rates over recent months. Additionally, the net declines in Treasury bill supply have put downward pressure on bill yields, which similarly affected rates on close substitutes to bills such as repurchase agreements (repos) collateralized by Treasury securities.³

In this environment of ample liquidity and downward pressure on money market rates, the Federal Reserve's ON RRP facility has seen a historically large increase in usage since April 2021, primarily driven by greater participation from government money market funds. Take-up at the ON RRP facility reached record levels—nearly $1 trillion by the end of June 2021. In light of the potential for expanded use of the facility and given growth in money market fund assets under management in recent years, the Federal Open Market Committee (FOMC) raised the per-counterparty cap on ON RRP participation to $80 billion per day from $30 billion at the March 2021 FOMC meeting. With the increase in usage, the ON RRP facility continued to serve its intended purpose of helping to provide a floor under short-term interest rates.⁴

The recent spike in facility usage reflected government money market funds turning to the facility because of their large inflows. Certain banks reportedly sought to limit further growth of their reserve holdings and of certain deposit liabilities. This phenomenon has reportedly been important in recent months in driving additional inflows into money market funds in lieu of bank deposits. Additionally, money market funds faced a relative lack of eligible short-term investments amid declining Treasury bill supply and reduced demand for repo funding on the part of borrowers. In this situation, the ON RRP has provided money market funds with an additional investment option for these inflows despite its offering rate being at 0 percent through mid-June.

Other deposits, another liability on the Federal Reserve's balance sheet, include deposits from government-sponsored enterprises (GSEs) and designated financial market utilities. These deposits roughly doubled since the beginning of 2021 to $408 billion by mid-June, reflecting in part the same money market conditions that drove higher ON RRP take-up.

Following the June 2021 FOMC meeting, the Federal Reserve made a technical adjustment to its administered rates: interest on excess reserves and the ON RRP offering rate. Both rates were increased 5 basis points in order to keep the federal funds rate well within the FOMC's target range and to support smooth functioning of short-term funding markets. ON RRP take-up rose substantially over subsequent days. This increase reflected shifts to the ON RRP from GSEs' deposits at the Federal Reserve that do not earn interest as well as additional participation from money market funds. Following the technical adjustment, short-term market interest rates adjusted slightly higher, largely in step with the increase in administered rates. The effective federal funds rate rose to 10 basis points, while the Secured Overnight Financing Rate increased to 5 basis points.