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Sound Monetary Policy for
Good Times and Bad

Merk Investments/Stanford SIEPR Panel
Stanford University
Palo Alto, California
October 20, 2009

Charles I. Plosser
President and CEO
Federal Reserve Bank of Philadelphia

The views expressed today are my own and not necessarily
those of the Federal Reserve System or the FOMC.

Sound Monetary Policy for Good Times and Bad
Charles I. Plosser
President and CEO
Federal Reserve Bank of Philadelphia
Merk Investments/Stanford SIEPR Panel
Stanford University
Palo Alto, California
October 20, 2009

I am delighted to be on tonight’s program, especially with an old friend and one of the
most respected contributors to the science of monetary policy: Bill Poole. I have known
Bill for nearly 30 years, and as both of us chose to move from academia into
policymaking, we share some experiences that such a transition offers. I have learned
and continue to learn a great deal from him, and so can you. So that makes tonight’s
event very special.
The theme of this evening’s discussion is “Monetary Policy in a Tough Environment.”
Well, that is an apt description of the world around us for the last two years. Policy
choices have been difficult. No one likes to be forced to choose the least bad option
among an even worse set of alternatives. Unfortunately, policymakers have, more than
once, faced just such a choice during this crisis.
The key message I want to leave you with this evening is that good policy — and by that
I mean policy that is clearly defined and systematically followed — should apply in good
times as well as in tough times. I do not mean that policy actions should necessarily be
the same in both good and bad economic times. Yet, in each environment, we should
conduct policy in a systematic way, one that is consistent, transparent, and largely
A systematic approach to policymaking does not mean that we can know what the future
holds or what future policy decisions will be. You often hear Fed officials say that policy
decisions are “data dependent” and, indeed, they are. This means that future policy
actions are conditional on how the economic data unfold — because the data inform our
economic outlook. The incoming economic data should feed into a decision-making
process in a mostly systematic way.
Some people think of this systematic approach to policy as a “reaction function” or what
economists call a state-contingent plan with parameters that are largely stable over time.
This approach is sometimes called “rule-like” policymaking. 1

See Charles Plosser, “The Benefits of Systematic Monetary Policy,” speech given to the National
Association for Business Economics, Washington Economic Policy Conference, Washington, D.C. (March
3, 2008).


Of course, the alternative to rule-like policy is discretionary policy, in which
policymakers are free to choose whatever action seems appropriate or convenient at the
time. Rules act as restrictions on policymakers’ choices — limiting the degree of
discretion. But this is not a bad thing; rather, it can result in better economic outcomes in
the long run.
Over the last three decades, economic theory and experience have taught us a lot about
good monetary policy, and many central banks around the world have put these lessons
into practice. Among the most important lessons are that policy should have clear
objectives and be systematic in its approach to achieving them. Doing so promotes both
transparency and predictability, which allow households and businesses to more
accurately form expectations and therefore make better decisions. As a result, systematic
policy promotes a more stable, predictable, and efficient economy.
Tonight I want to suggest ways to apply systematic approaches to central bank
policymaking. I believe that this is the best way to ensure that policymaking will be better
prepared for the next “tough environment,” whenever it comes and whatever its source.
It also helps to avoid sowing the seeds of a new crisis.
I want to stress that a systematic approach applies not just to traditional monetary policy
but also to a central bank’s role as the lender of last resort. While these two aspects of
central banking are different, the approach to policymaking ought to be the same — that
is, systematic, consistent, transparent, and largely predictable — whether in good times or
Systematic Monetary Policy
To adopt a systematic approach to monetary policy, we first must ensure that policy has
clear, well-defined, and feasible objectives. Congress has established our so-called dual
mandate that monetary policy seek to achieve price stability and maximum employment.
Policymakers must credibly commit to take actions that will deliver on these stated
objectives. Many economists and central bankers believe that creating an environment of
stable prices is the most valuable contribution a central bank can make to promoting
maximum employment and sustainable economic growth. What’s more, central banks
have a unique responsibility for price stability, at least in a flexible exchange rate regime.
As a consequence, central banks in a number of countries have adopted institutional
mechanisms to reinforce the credibility of their commitment to such an objective.
One such approach is to adopt an explicit inflation target, which I and other economists
have long proposed as a way to help clarify the central bank’s policy objective and as a
way to publicly commit the institution to a feasible goal easily understood by all. This
can help to anchor inflation expectations if the public finds the commitment credible. A
lack of confidence in the central bank’s commitment to maintain price stability, for
example, can lead to rising inflation expectations that prompt workers and firms to
demand higher wages and prices to head off the expectation of higher costs, thus setting
off a burst of inflation. A credible inflation target would not only help prevent inflation

expectations and actual inflation from rising to undesirable levels, but it would also help
prevent expectations of deflation from materializing that could initiate an undesirable
episode of falling prices.
Marvin Goodfriend, for example, has documented episodes during the 1980s and early
1990s when markets lost confidence in the Fed’s commitment to price stability. During
these episodes — which Goodfriend calls inflation scares 2 — long-term interest rates
rose sharply as expectations of inflation rose. To restore the Fed’s credibility and ensure
better long-run economic outcomes, the Fed had to aggressively increase short-term
interest rates to reduce inflation expectations, even though doing so risked potentially
undesirable consequences for the broader economy.
Deflation scares can be just as problematic. Twice in this decade alone we have seen
concerns that deflation may pose a threat. In 2003, the Fed responded by dropping the
nominal federal funds rate target to 1 percent and holding it there for a prolonged period
to reassure the public and markets of its commitment to price stability. Many have argued
that by doing so, we risked contributing to excessive asset-price speculation.
Just this year, concerns about deflation surfaced again. Yet with the federal funds rate
already near zero, the Fed could not cut rates further. So, with expectations of deflation
looming, real, or inflation-adjusted, short-term interest rates were rising, potentially
putting at risk the economy’s recovery.
These cases help illustrate that maintaining a firm commitment to low and stable inflation
helps prevent inflation expectations from rising or falling, which promotes a more
sustainable and robust economy. The greater predictability of an inflation-targeting
regime amounts to articulating in advance the “rules of the game” as best as possible —
even in a crisis. In this way, systematic policy can provide an important stabilizing
influence on the real economy at a time when it is very much needed.
A frequently expressed concern is that an inflation-targeting regime is unresponsive to
fluctuations in the real economy. This is a misconception. The economy is constantly
buffeted by shocks, and markets respond by making adjustments in prices and quantities
as required. One of those important prices is the real interest rate. It is not a constant but
moves around. Monetary policy must recognize this and adjust accordingly. If the real
interest rate falls, signaling weak growth, then so must the nominal federal funds rate if
inflation is near the target. Otherwise, policy would be fostering an inflation rate below
its target. Likewise, as economic growth rates and real interest rates rise, the nominal
federal funds rate must also rise in order to keep inflation from rising above the desired
rate. This is not necessarily an easy or straightforward task, but it is nonetheless the
appropriate way to think about policy.
One of the most well-known forms of systematic monetary policy was described by John
Taylor when he explored how the central bank should set the short-term nominal interest

See Marvin Goodfriend, “Interest Rate Policy and the Inflation Scare Problem: 1979-1992,” Federal
Reserve Bank of Richmond Economic Quarterly (Winter 1993), pp 1-23.


rate. 3 These Taylor rules require central banks to have an inflation target of some kind,
and they are more explicit about exactly how the central bank should respond to
deviations from the target. There are many variations of Taylor’s rule, but all share the
vital characteristic that they systematically describe the behavior of policy. Another
advantage of these simple Taylor-like rules is that they make it easier for the public and
financial markets to form expectations about policy, and therefore, they can contribute to
a more stable and efficiently functioning economy.
Some of these Taylor-like rules yield very good results in a variety of theoretical settings
because they produce outcomes close to those of the theoretically optimal rule. 4
Furthermore, this occurs in a wide variety of models of the type actually used to shape
our forecasts and our understanding of actual economic events. 5
In these simple rules, the interest rate generally responds aggressively to inflation or to
the forecast of inflation, which implies that the real rate of interest should rise when
inflation or projected inflation increases above its target. Although these rules imply that
the interest rate should respond positively to deviations of actual output from some
measure of “potential output,” the interest rate’s response to output movements is usually
quite a bit smaller than its response to inflation.
Economists generally view these Taylor-like rules as working in both good and bad
times. When economic activity is rapidly growing and inflation is rising, the rule would
be systematically applied to raise interest rates to keep inflation in check. When
economic activity is declining and inflation is slowing, the rule would ease interest rates
to foster the conditions that enable households and businesses to make the necessary
adjustments to return the economy to its long-term growth path.
As the economic outlook worsened in late 2007 and 2008 and we experienced the early
stages of the financial crisis, the FOMC lowered its federal funds rate target more than
many versions of Taylor-like rules would have required. When monetary policymakers
who follow a rule choose to significantly deviate from the rule for unusual and temporary
reasons, they must be transparent in explaining why so as not to undermine their
credibility with the public regarding their systematic approach to policy goals. In light of
the severity of the disruptions to financial markets during this crisis, explaining such a
deviation might not have been difficult for the Fed or other central banks during this
However, with a major financial crisis and the federal funds rate target reaching the zero
bound, implementing an interest rate rule can become problematic. In particular, during

See John B. Taylor, “Discretion Versus Policy Rules in Practice,” Carnegie-Rochester Conference Series
on Public Policy 39 (1993), pp. 195-214.
See Plosser’s March 3, 2008 speech cited in footnote 1.
See Andrew Levin, Volker Wieland, and John C. Williams, “The Performance of Forecast-Based
Monetary Policy Rules under Model Uncertainty,” American Economic Review 93:3 (June 2003), pp. 62245. Also see Stephanie Schmitt-Grohe and Martin Uribe, “Optimal Simple and Implementable Monetary
and Fiscal Rules,” Federal Reserve Bank of Atlanta Working Paper 2007-24 (2007).


the depth of the financial crisis and amid the sharp declines in economic activity, some
versions of the Taylor rule called for reductions in real interest rates that would have
meant further cuts in the nominal federal funds rate target when it was already near zero.
Since that is not feasible, economists and policymakers have to consider how to adapt
such policy rules. Some have suggested that in such circumstances, quantitative rules are
more appropriate, perhaps similar to the rules suggested by Bennett McCallum that focus
on growth of the monetary base. 6 Such rules could be mapped into metrics for assessing
the appropriate degree of quantitative easing or the expansion of the Federal Reserve’s
balance sheet.
As we review the current crisis, economists and policymakers will need to determine the
appropriate extent of deviations from a policy rule. We might also ask if there are
variations of these rules that could be articulated in advance and that would be more
adaptable in the extreme circumstances we have witnessed during this crisis.
Nevertheless, by using simple rules as the benchmark, policymakers would be forced to
explain deviations, thereby helping to make policy more transparent.
If we are to keep expectations of inflation well-anchored, departures from a systematic
approach to monetary policy must be clearly communicated and promptly reversed as
conditions return to normal. Otherwise, we risk eroding the public’s confidence in our
commitment to deliver price stability, and we know from the 1970s and early 1980s that
the cost of regaining the public’s confidence can be quite high.
This leads me to my last point concerning systematic monetary policy. In order to capture
the benefits of such a policy, the public must believe that policymakers will stick to their
goals and the rules adopted to achieve them. If policymakers fail to act in a way
consistent with the stated objectives, credibility is lost and the public becomes uncertain
about how policymakers will react in the future. That is surely a recipe for volatility, not
stability. This is one reason transparency is important. When policymakers are
transparent about how they are setting policy, the public can verify that policymakers are
acting in a way consistent with their stated objectives, and thus, the policymakers gain
credibility and the economy gains stability.

Systematic Lender-of-Last-Resort Policy
Just as we need to pursue a systematic approach to monetary policy, I believe we must
also apply a systematic approach to the central bank’s financial stability policy,


See Bennett McCallum, “Robustness Properties of a Rule for Monetary Policy,” Carnegie- Rochester
Conference Series on Public Policy 29 (Autumn 1988), pp. 173-203. McCallum proposed a rule that calls
for varying the growth rate of the monetary base (currency and bank reserves) in response to variations in
nominal GDP and a proxy for long-run trends in money demand. The rule specifies a target for nominal
GDP that is the sum of the economy’s long-run trend growth of real GDP and a desired or targeted inflation
rate. If nominal GDP growth is above the target, the rule calls for reducing the growth rate of the monetary
base and vice versa.


particularly its policy actions as the lender of last resort. In light of the crisis, academics
and policymakers are taking a much greater interest in this aspect of central banking.
The best guide to a systematic lender of last resort policy dates back to Walter Bagehot’s
simple rule of lending freely to solvent banks at a penalty rate against good collateral. 7
During the past year, the Fed has taken extraordinary actions to ensure financial stability
that have gone far beyond this concept. Some of these actions have supported markets in
which intermediation was severely impaired; others have supported the ongoing survival
of institutions deemed too big to fail.
Financial market conditions have continued to improve over the past year. However, I
believe abandoning Bagehot’s simple rule has increased moral hazard and the associated
risk for our financial system.
Because a financial crisis of this magnitude does not occur often, policymakers had little
experience to draw upon. As events moved quickly, we ended up learning as we went.
So it is probably not surprising that policy reactions appeared, at times, erratic, rather
than systematic. Yet, in the process, we have learned that not having a clearly
communicated systematic approach to our lending that covers bad — and really bad —
times can be very confusing to the public and the markets.
This was underscored by the public and market reaction to the Fed’s and the Treasury’s
varying approaches during 2008 to the serious problems that arose at three financial
firms: Bear Stearns, Lehman Brothers, and the global insurer AIG. The lack of a clearly
understood approach to the government’s and the Fed’s decisions about when assistance
efforts would be provided created confusion and uncertainty.
A significant factor contributing to the difficult policy choices was the lack of an explicit
resolution mechanism for the orderly failure of a systemically important nonbank
financial firm. In fact, we still do not have such a mechanism 18 months after the Bear
Stearns merger. The lack of a well-articulated systematic approach to the Fed’s lending
role contributed to uncertainty in financial markets about who would be “rescued” and
who would not. That uncertainty still remains and must be one of the prime objectives of
policy reforms going forward.
I believe that no firm should be too big to fail and that a body other than the Fed should
have the authority to fail these firms, wipe out shareholders’ stakes in the firm, force
uninsured creditors to take haircuts, and unwind the firm in an orderly manner. The real
challenge in such an approach is whether a policymaker can make a credible commitment
to behave in such a manner. Won’t there always be some firms that might gamble on a
rescue in something like a game of chicken with the government? Does this really
eliminate moral hazard? Probably not entirely, but it is likely to substantially improve the

Walter Bagehot, Lombard Street: A Description of the Money Market (New York: E.P. Dutton and
Company, 1921). [ 1873]


As the crisis unfolded and problems arose in different parts of the financial system, the
Fed responded by trying to increase liquidity in several markets through special lending
programs. These programs may have had some stabilizing effects on markets and may
have lowered some spreads. Yet, without defining in advance a systematic and consistent
approach to such lending, these programs also raised uncertainty — in this case, about
who would or would not have access to the various facilities. This was illustrated when
the Term Asset-Backed Securities Loan Facility (or TALF) was announced. Many market
participants lobbied for expanding the categories of securities eligible for the program.
Did these multiple lending programs keep lenders on the sidelines waiting to see which
asset classes the Fed would support and which it would not? Did this delay the healing of
the financial markets?
In hindsight, a basic problem was that, in our desire to get financial markets working
again, we offered no systematic view as to how and where the Fed would intervene — we
lacked a well-communicated systematic approach. Moreover, to my way of thinking, we
strayed into credit allocation that, in my view, should be the purview of fiscal authorities
and not the central bank.
Going forward, to promote a clearer distinction between monetary policy and fiscal
policy and help safeguard the Fed’s independence, I have advocated that the Fed and the
Treasury should agree that the Treasury will take the non-Treasury assets and nondiscount window loans from the Fed’s balance sheet in exchange for Treasury securities. 8
Such a new “accord” would transfer funding for these special credit programs to the
Treasury — which would issue Treasury securities to fund the transfer — thus ensuring
that these extraordinary credit policies are under the oversight of the fiscal authority,
where such policies rightfully belong. The accord would return control of the Fed’s
balance sheet to the Fed, so that it can continue to conduct independent monetary policy. 9
I would go further and suggest that the Fed adopt an “all Treasuries policy” for the
securities held on its balance sheet and follow Bagehot’s principle for the loans on its
balance sheet — which in a crisis would mean the Fed would lend freely to solvent firms
with good collateral at a penalty rate.


See Charles Plosser, “Ensuring Sound Monetary Policy in the Aftermath of Crisis,” speech given to the
U.S. Monetary Policy Forum, The Initiative on Global Markets, University of Chicago Booth School of
Business, New York, NY (February 27, 2009). For a discussion of such an accord between the Fed and the
Treasury in a different context, see J. Alfred Broaddus, Jr. and Marvin Goodfriend’s article, “What Assets
Should the Federal Reserve Buy?” and Goodfriend’s article, “Why We Need an ‘Accord’ for Federal
Reserve Credit Policy: A Note,” Federal Reserve Bank of Richmond Economic Quarterly (Winter 2001).
Such an accord would also be consistent with the recommendations made by the Group of Thirty’s
Working Group on Financial Reform about the role of central banks in providing financial stability. See
“Financial Reform: A Framework for Financial Stability,” Group of Thirty, Washington, D.C. (2009).
There is a historical precedent for such an accord. In 1951, the Treasury and the Fed struck an accord that
freed the Fed from pegging the interest rate on long-term Treasury debt below 2.5 percent, which the Fed
had done during and after World War II. For several articles about the 1951 Accord, see the Federal
Reserve Bank of Richmond’s Economic Quarterly (Winter 2001).


I believe we must specify in advance the conditions under which the central bank would
serve as a lender of last resort. This policy should be systematic and should apply to both
good times and bad. It should have clear, realistic, and feasible objectives; it should be
consistent, transparent, and predictable; and it should operate independently of interest
group pressures to lend to specific sectors or industries.
Developing such a systematic approach is not easy. Making a credible commitment to
stick to such a lending policy in good times and bad is even more difficult. Nevertheless,
that is what we must tackle if we are going to achieve better results the next time a crisis
Going forward, the Fed as well as other policymakers should strive to follow a
systematic, more “rule-like” approach in bad times as well as good. Developing and
implementing such systematic rules for making sound policy in all seasons deserves more
attention by policymakers because they would yield better economic outcomes for both
monetary policy and financial stability policy. I believe that times of crisis are precisely
when sound principles and a systematic approach to policy are most needed.