Board of Governors of the Federal Reserve System

Principles for the Conduct of Monetary Policy

Three key principles of good monetary policy
Over the past decades, policymakers and academic economists have formulated several key principles for the conduct of monetary policy; these principles are based on historical experience with a range of monetary policy frameworks.¹

One principle is that monetary policy should be well understood and systematic. The objectives of monetary policy should be stated clearly and communicated to the public. The Congress has directed the Federal Reserve to use monetary policy to promote both maximum employment and price stability; those are the objectives of U.S. monetary policy. Fed policymakers' understanding of that statutory mandate is summarized in Monetary Policy: What Are Its Goals? How Does It Work? To be systematic, policymakers should respond consistently and predictably to changes in economic conditions and the economic outlook; policymakers also should clearly explain their policy strategy and actions to the public, and they should follow through on past policy announcements and communications unless circumstances change in ways that warrant adjusting past plans. Following this principle helps households and firms make economic decisions and plan for the future; it also promotes economic stability by avoiding policy surprises.

A second principle is that the central bank should provide monetary policy stimulus when economic activity is below the level associated with full resource utilization and inflation is below its stated goal. Conversely, the central bank should implement restrictive monetary policy when the economy is overheated and inflation is above its stated goal. In some circumstances, the central bank should follow this principle in a preemptive manner. For example, economic developments such as a large, unanticipated change in financial conditions might not immediately alter inflation and employment but would do so in the future and thus might call for a prompt, forward-looking policy response. Conveying how monetary policy would respond to irregular future events is not easy, but the overarching principle remains the same: Policymakers should strive to communicate how these events may affect the future evolution of inflation and employment and set monetary policy accordingly.

A third principle is that the central bank should raise the policy interest rate, over time, by more than one-for-one in response to a persistent increase in inflation and lower the policy rate more than one-for-one in response to a persistent decrease in inflation. For example, if the inflation rate rises from 2 percent to 3 percent and the increase is not caused by temporary factors, the central bank should raise the policy rate by more than one percentage point. Such an adjustment to the policy rate translates into an increase in the real policy rate--that is, the level of the policy rate adjusted for inflation--when inflation rises and a decrease in the real policy rate when inflation slows. As the real policy rate rises, it feeds through to other real interest rates that determine how expensive it is for households and businesses to borrow money to finance consumption or investment spending, adjusted for inflation. Raising real interest rates tends to reduce growth of economic activity, and firms tend to increase prices less rapidly when they see slower growth in their sales. As a result, inflation is kept in check. A symmetric logic applies to the central bank's response to persistent decreases in inflation.

In the academic research literature, a standard way to codify these principles is to assume that policymakers set the policy rate according to an equation or policy rule that relates the policy rate to a small set of economic variables. One such rule is the Taylor rule.

The Taylor rule
In an article published in 1993, John Taylor showed how U.S. monetary policy from 1987 through 1992 could be approximated fairly well by a simple equation that linked the level of the federal funds rate--the policy interest rate of the Federal Reserve--to three variables. The first variable is the neutral value of the policy interest rate in the longer run (adjusted for inflation). The second is the deviation of current inflation from the Federal Open Market Committee's (FOMC) objective. And the third is the percentage difference of gross domestic product (GDP) from its potential level--the level of output associated with the full utilization of resources.² Taylor's simple equation takes the following general form:

$$$$ FFR_t = r_t^{LR} + \pi_t + 0.5(\pi_t - \pi^*) + 0.5(y_t - y_t^P), $$$$

where $$ FFR_t $$ is the federal funds rate in quarter $$ t$$, $$ r_t^{LR} $$ is the neutral federal funds rate in the longer run (adjusted for inflation), $$ \pi_t $$ is the four-quarter inflation rate, $$ \pi^* $$ is the central bank's objective for inflation, and $$ y_t - y_t^P $$ measures the percentage difference of GDP from its potential level.³ Taylor set the value of $$ r_t^{LR} $$ at a constant level of 2 percent and assumed the Fed's inflation objective, $$ \pi^*$$, was 2 percent. If inflation is running at 2 percent and GDP is equal to its potential level, then Taylor's formula prescribes setting the federal funds rate at 4 percent. If inflation moves above 2 percent, the equation increases the federal funds rate by 1.5 times the increase in inflation. If GDP exceeds its potential level, then the equation increases the federal funds rate by 0.5 times the percentage difference of GDP from its potential level.

This so-called Taylor rule reflects the three key principles of monetary policy discussed previously. First, the equation makes the policy interest rate predictable if the neutral real federal funds rate in the longer run, the actual and target inflation rates, the level of real GDP, and its potential level are known. Second, it prescribes an increase in the policy rate when inflation rises or resource utilization rises--and a decrease when inflation falls or resource utilization falls--consistent with the Federal Reserve's dual mandate to foster maximum sustainable employment and price stability. Third, the equation prescribes that the federal funds rate be adjusted by more than one-for-one when inflation rises or falls--this feature is sometimes called the Taylor principle.

In subsequent work, Taylor (1999) argued that the equation he proposed in 1993 performed well in the context of economic models when it was used to simulate monetary policy in such models.⁴ Taylor showed that, in simulations of the models he considered, monetary policy that adhered to his rule tended to do reasonably well in stabilizing inflation rates close to 2 percent and unemployment rates close to the maximum rates that were sustainable over the longer run in those models.

While Taylor's equation performs well in a set of economic models, these models omit features of the actual economy that are relevant for monetary policy.⁵ Unfortunately, it is often only with the benefit of hindsight that the importance of simplifications and omissions in economic models is fully appreciated. For example, before the Global Financial Crisis that began in 2007, most existing economic models of the United States and other countries did not accurately reflect how much problems in the financial sector could affect the rest of the economy. This oversight became apparent during the Global Financial Crisis. In his 1993 article, Taylor pointed out that "operating monetary policy by mechanically following a policy rule . . . is not practical," in part because there would be episodes in which "monetary policy will need to be adjusted to deal with special factors."⁶ Over the period since Taylor wrote those words, the Global Financial Crisis would seem to be the most prominent example of such an episode.

In practice, policymakers exercise judgment in determining the appropriate level for the policy rate while taking into account data from a wide variety of sources, not just the current values of inflation and unemployment. For example, movements in measures of financial conditions, financial innovation, expectations about inflation and output, changes in the composition of the labor market, and economic developments abroad can all affect future values of inflation and unemployment. As a result, policymakers need to adjust the federal funds rate in response to incoming data so as to achieve the central bank's objectives; policy rules that narrowly focus on one or two economic variables are likely to miss or lag behind important developments in the economy.

In addition, the FOMC has made decisions about aspects of monetary policy other than just the policy interest rate. Over the past decade, policymakers have changed the size and composition of the Federal Reserve's balance sheet, issued forward guidance on the likely path for the federal funds rate in the future, and announced likely changes in balance sheet policy before making those changes. The Taylor rule is silent on how to take such decisions, in part because the simple economic models in which rules are commonly studied usually ignore the effect of such decisions on inflation and economic activity.

While the Taylor rule is among the best-known formulations of a relationship between the short-term policy rate and other economic variables, a wide range of alternative formulations have been proposed. Specifying a particular rule requires making a number of decisions: Should the policy rate be specified in terms of the level of the policy interest rate or its change from the previous period? Should the policy rate respond to the rate of inflation or the price level? Should it respond to quarter-over-quarter or year-over-year inflation or even to a forecast of future inflation? Should it respond to the resource utilization gap, the unemployment gap, or both--or even to other measures such as credit growth or asset prices? Finally, how strongly and how fast should the policy rate respond to changes in each of these items? For alternatives to the Taylor rule and answers to some of these questions, see Policy Rules and How Policymakers Use Them.

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