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EMBARGOED UNTIL FRIDAY, OCTOBER 13, 2017 AT 8:35 A.M.; OR UPON DELIVERY Making Monetary Policy: Rules, Benchmarks, Guidelines, and Discretion Eric S. Rosengren President & CEO Federal Reserve Bank of Boston October 13, 2017 Federal Reserve Bank of Boston’s 61st Economic Conference “Are Rules Made to be Broken? Discretion and Monetary Policy” Boston, Massachusetts bostonfed.org Should We Have Rules-Based Monetary Policy? ▶ Legislation is being considered that has policymakers adhere to predetermined rule ▶ “Taylor Rule” – leading example of rules ▶ Legislation closely follows Taylor (1993) ▶ Alternative is to focus on outcomes ▶ Maximum employment and stable prices ▶ Allow policymakers discretion in determining how best to achieve the mandate 2 Benefits of Policy Rules ▶ Rules can capture the response of policy to various conditions over a historical period, providing a benchmark ▶ Rules can make inherently complex policies more understandable and transparent to the public ▶ Greater transparency can make it easier to communicate the current and prospective stance of monetary policy ▶ Provide consistency through time, even as the membership of the policymaking committee changes 3 Drawbacks – A Historical Example ▶ Boston Fed President Frank Morris, 35 years ago, a leader in the rules versus discretion debate ▶ Many economists were arguing for rules tied to simple money aggregates ▶ Frank argued financial innovation had degraded the information content of money aggregates, so simple money-based rules would be poor guides for monetary policy ▶ With the benefit of hindsight, I think it is clear that Frank Morris was right – money aggregates largely disappeared from policy debates 4 Potential Issues with Rules ▶ No simple policy rule has been widely adopted to direct policy at central banks around the world ▶ Picking the wrong rule can entail significant costs: an ineffective or inappropriate rule could produce distinctly sub-optimal results for the economy ▶ Costly to a central bank’s reputation and communication efforts if the rule has to be abandoned 5 Current Rules Have Significant Advantages Over Money Aggregates ▶ They are firmly tied to the ultimate goals that Congress has set for the Federal Reserve ▶ A policy rule that guides actions (interest rate decisions) to reduce misses in the mandate (deviations of inflation and employment from their targets) makes intuitive sense ▶ I will show why benchmarking with policy rules is essential – and why legislating the use of simple policy rules would be counterproductive 6 Figure 1: Inflation Rate: Change in Personal Consumption Expenditures (PCE) Price Index January 1970 - August 2017 12 Percent Change from Year Earlier 9 6 3 0 -3 Jan-1970 Jan-1980 Jan-1990 Jan-2000 Jan-2010 Recession Source: BEA, NBER, Haver Analytics 7 Figure 2: Civilian Unemployment Rate and the Natural Rate of Unemployment 1970:Q1 - 2017:Q3 12 Percent 9 6 3 Civilian Unemployment Rate Natural Rate of Unemployment 0 1970:Q1 1980:Q1 1990:Q1 2000:Q1 2010:Q1 Recession Source: BLS, CBO, NBER, Haver Analytics 8 Figure 3: Specifications of Policy Rules for the Federal Funds Rate December 8, 2011 Note: it is the federal funds rate for quarter t, yt - yt* is the output gap estimate for the current period, 𝜋t is the trailing four-quarter core PCE inflation for quarter t, and 𝜋t*, policymakers’ long-run inflation objective, is assumed to be 2%. The symbol ∆ 4 refers to the change over 4 quarters, and 𝜋t+2|t refers to inflation expectations formed at time t for two quarters ahead. Source: FOMC, Tealbook B, December 8, 2011 9 Rules Do Provide an Important Benchmark ▶ FOMC participants do indeed regularly refer to policy rules – previous table shows they have been used regularly in briefing documents ▶ Help reinforce dual mandate – ▶ Reinforce the expectations of firms and households that inflation is likely to be 2 percent ▶ Reinforce commitment to full employment 10 Figure 4: Near-Term Prescriptions of Policy Rules for the Federal Funds Rate December 8, 2011 Taylor (1993) rule 2012Q1 0.90 2012Q2 0.59 Taylor (1999) rule -1.82 -2.15 Estimated outcome-based rule -0.11 -0.42 Estimated forecast-based rule -0.27 -0.61 First-difference rule -0.02 -0.14 MEMO Staff assumption Fed funds futures Median expectation of primary dealers Blue Chip forecast (December 1, 2011) Source: FOMC, Tealbook B, December 8, 2011 2012Q1 0.08 0.10 0.13 0.10 2012Q2 0.10 0.13 0.13 0.10 11 Figure 5: Federal Reserve System Assets January 1990 - September 2017 5 Trillions of Dollars 4 3 2 1 0 Jan-1990 Jan-2000 Jan-2010 Recession Source: Federal Reserve Board, NBER, Haver Analytics 12 Figure 6: Federal Reserve System Balance Sheet Composition January 1990 - September 2017 5 Trillions of Dollars Other Assets 4 Mortgage-Backed Securities Maturing in More Than 10 Years Treasury Securities Maturing in More Than 10 Years Treasury Securities Maturing in 5 to 10 Years Treasury Securities Maturing in 1 to 5 Years Treasury Securities Maturing in 1 Year or Less 3 2 1 0 Jan-1990 Jan-2000 Jan-2010 Source: Federal Reserve Board, NBER, Haver Analytics 13 Figure 7: Estimates of the Equilibrium Real Interest Rate January 2012 - September 2017 3 Percent 2 1 Central Tendency SEP Median Longer-Run Real Federal Funds Target Rate 0 Jan-2012 Dec-2012 Dec-2013 Dec-2014 Dec-2015 Dec-2016 Date of Forecast Note: The equilibrium real interest rate is calculated as the SEP median longer-run federal funds rate forecast less an inflation rate of 2%. The central tendency excludes the three highest and three lowest observations. Source: FOMC, Summary of Economic Projections (SEP) 14 Figure 8: Estimates of the Natural Rate of Unemployment: SEP Forecasts of the Longer-Run Unemployment Rate January 2009 - September 2017 6.5 Percent 5.5 4.5 Central Tendency SEP Median Longer-Run Unemployment Rate 3.5 Jan-2009 Jan-2011 Dec-2012 Dec-2014 Date of Forecast Dec-2016 Note: Prior to the June 2015 median, SEP median unemployment rates are publicly available only with a five-year lag. Proxies for the medians for 2012 - March 2015 are calculated from the distribution of participants’ projections reported in ranges of tenths in the meeting minutes. The central tendency excludes the three highest and three lowest observations. Source: FOMC, Summary of Economic Projections (SEP) 15 Figure 9: Taylor Rule Prescriptions for the Federal Funds Rate January 2012 - August 2017 6 Percent R*=2.25% and NAIRU=5.45% - Jan 2012 SEP R*=0.75% and NAIRU=4.6% - Sept 2017 SEP 4 2 0 -2 Jan-2012 Jan-2014 Jan-2016 Note: To specify the rule in terms of the Fed’s dual mandate, which is stated in terms of employment rather than output, the output gap has been replaced by the gap between the longer-run and actual rates of unemployment, using Okun’s Law. The calculation uses the PCE inflation rate. Source: FOMC, Summary of Economic Projections (SEP); Taylor Rule (1993) 16 Challenges with Policy Rules ▶ Simple interest rate rules do not capture the full range of policy instruments available to the central bank ▶ Parameters often specified as constants in simple policy rules have proven to be quite variable ▶ Estimates of full employment and the equilibrium real interest rate have changed significantly over a short period of time ▶ Given the changing views of economic relationships as we get more information about how the economy is actually responding, there would be many deviations from the rule and many complex explanations required ▶ Not incorporating financial stability and tail risks will not fully capture how policymakers react in real time ▶ Significant omission during recessions and financial crises 17 Figure 10: Errors in the Estimated Taylor Rule and Periods of Instability February 11, 1987 - December 15, 2008 1 Black Monday 0.75 Bank of New England Fails Asian Crisis Russian Crisis/ LTCM Argentine Debt Default Bear Stearns Fails Lehman Fails 0.5 0.25 0 -0.25 -0.5 -0.75 -1 -1.25 1987 1988 1989 1990 1991 1992 1993 1994 1995 1996 1997 1998 1999 2000 2001 2002 2003 2004 2005 2006 2007 2008 Recession Residual (Actual-Fitted): FFR=C+B1*FFR(-1)+B2*URF4 +B3*PFA Source: Peek, Rosengren and Tootell. (2016) “Does Fed Policy Reveal a Ternary Mandate?” Federal Reserve Bank of Boston Working Paper 16-11 18 Concluding Observations ▶ Simple policy rules are useful, not least in capturing how monetary policy has reacted historically ▶ This makes these rules very useful benchmarks providing useful guidance ▶ A legislated policy rule that is rigid could lead to large policy mistakes ▶ Key inputs to policy rules that can change over time are estimated with substantial error 19 Concluding Observations (Continued) ▶ Policy effectiveness is better served by a more robust formulation of monetary policy that draws on a diverse set of guidelines and benchmarks – which is the exercise Fed policymakers conduct every six weeks for actual FOMC meetings 20
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