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June 6, 2012

Perspectives on Monetary Policy

Remarks by
Janet L. Yellen
Vice Chair
Board of Governors of the Federal Reserve System
at the
Boston Economic Club Dinner
Federal Reserve Bank of Boston
Boston, Massachusetts

June 6, 2012
 
 

Good evening. I’m honored to have the opportunity to address the Boston Economic
Club and I’m grateful to Chip Case for inviting me to speak to you tonight. As most of you
probably know, Chip was one of the first economists to document worrisome signs of a housing
bubble in parts of the United States. After sounding an early alarm in 2003, Chip watched the
bubble grow and was prescient in anticipating the very serious toll that its unwinding would
impose on the economy. Chip recognized that declining house prices would affect not just
residential construction but also consumer spending, the ability of households to borrow, and the
health of the financial system. In light of these pervasive linkages, the repeat sales house price
index that bears Chip’s name is one of the most closely watched of all U.S. economic indicators.
Indeed, as I will discuss this evening, prolonged weakness in the housing sector remains one of
several serious headwinds facing the U.S. economy. Given these headwinds, I believe that a
highly accommodative monetary policy will be needed for quite some time to help the economy
mend. Before continuing, let me emphasize that my remarks reflect my own views and not
necessarily those of others in the Federal Reserve System.1
Economic Conditions and the Outlook
In my remarks tonight, I will describe my perspective on monetary policy. To begin,
however, I’ll highlight some of the current conditions and key features of the economic outlook
that shape my views. To anticipate the main points, the economy appears to be expanding at a
moderate pace. The unemployment rate is almost 1 percentage point lower than it was a year
ago, but we are still far from full employment. Looking ahead, I anticipate that significant
headwinds will continue to restrain the pace of the recovery so that the remaining employment
                                                            
1

I appreciate assistance from members of the Board’s staff--Jon Faust, Thomas Laubach, Andrew Levin, and David
Reifschneider--who contributed to the preparation of these remarks.
 

-2 

gap is likely to close only slowly. At the same time, inflation (abstracting from the transitory
effects of movements in oil prices) has been running near 2 percent over the past two years, and I
expect it to remain at or below the Federal Open Market Committee’s (the FOMC’s) 2 percent
objective for the foreseeable future. As always, considerable uncertainty attends the outlook for
both growth and inflation; events could prove either more positive or negative than what I see as
the most likely outcome. That said, as I will explain, I consider the balance of risks to be tilted
toward a weaker economy.
Starting with the labor market, conditions have gradually improved over the past year,
albeit at an uneven pace. Average monthly payroll gains picked up from about 145,000 in the
second half of 2011 to 225,000 during the first quarter of this year. However, these gains fell
back to around 75,000 a month in April and May. The deceleration of payroll employment from
the first to the second quarter was probably exacerbated by some combination of seasonal
adjustment difficulties and an unusually mild winter that likely boosted employment growth
earlier in the year. Payback for that earlier strength probably accounts for some of the weakness
we’ve seen recently. Smoothing through these fluctuations, the average pace of job creation for
the year to date, as well as recent unemployment benefit claims data and other indicators, appear
to be consistent with an economy expanding at only a moderate rate, close to its potential.
Such modest growth would imply little additional progress in the near term in improving
labor market conditions, which remain very weak. Currently, the unemployment rate stands
around 3 percentage points above where it was at the onset of the recession--a figure that is stark
enough as it is, but does not even take account of the millions more who have left the labor force
or who would have joined under more normal circumstances in the past four years. All told,
only about half of the collapse in private payroll employment in 2008 and 2009 has been

-3 

reversed. A critical question for monetary policy is the extent to which these numbers reflect a
shortfall from full employment versus a rise in structural unemployment. While the magnitude
of structural unemployment is uncertain, I read the evidence as suggesting that the bulk of the
rise during the recession was cyclical, not structural in nature.
Consider figure 1, which presents three indicators of labor market slack. The black solid
line is the unemployment gap, defined as the difference between the actual unemployment rate
and the Congressional Budget Office (CBO) estimate of the rate consistent with inflation
remaining stable over time. The red dashed line is an index of the difficulty households perceive
in finding jobs, based on results from a survey conducted by the Conference Board. And the red
dotted line is an index of firms’ ability to fill jobs, based on a survey conducted by the National
Federation of Independent Business. All three measures show similar cyclical movements over
the past 20 years, and all now stand at very high levels. This similarity runs counter to claims
that the CBO’s and other estimates of the unemployment gap overstate the true amount of slack
by placing insufficient weight on structural explanations, such as a reduced efficiency of
matching workers to jobs, for the rise in unemployment since 2007. If that were the case, why
would firms now find it so easy to fill positions? Other evidence also points to the dominant role
of cyclical forces in the recent rise in unemployment: job losses have been widespread, rather
than being concentrated in the construction and financial sectors, and the co-movement of job
vacancies and unemployment over the past few years does not appear to be unusual.2
As I mentioned, I expect several factors to restrain the pace of the recovery and the
corresponding improvement in the labor market going forward. The housing sector remains a
                                                            
2

For further discussion of evidence of labor market slack, see Janet L. Yellen (2012), “The Economic Outlook and
Monetary Policy,” speech delivered at the Money Marketeers of New York University, New York, April 11,
www.federalreserve.gov/newsevents/speech/yellen20120411a.htm.  

-4 

source of very significant headwinds. Housing has typically been a driver of economic
recoveries, and we have seen some modest improvement recently, but continued uncertainties
over the direction of house prices, and very restricted mortgage credit availability for all but the
most creditworthy buyers, will likely weigh on housing demand for some time to come. When
housing demand does pick up more noticeably, the huge overhang of both unoccupied dwellings
and homes in the foreclosure pipeline will likely allow a good deal of that demand to be met for
a time without a sizeable expansion in homebuilding. Moreover, the enormous toll on household
wealth resulting from the collapse of house prices--almost a 35 percent decline from its 2006
peak, according to the Case-Shiller index--imposes ongoing restraint on consumer spending, and
the loss of home equity has impaired many households’ ability to borrow.
A second headwind that will likely become more important over coming months relates
to fiscal policy. At the federal level, stimulus-related policies are scheduled to wind down, while
both defense and nondefense purchases are expected to decline in inflation-adjusted terms over
the next several years. Toward the end of this year, important decisions regarding the extension
of current federal tax and budget policies loom. I will return to the associated uncertainties and
their potentially detrimental effects later.
A third factor weighing on the outlook is the likely sluggish pace of economic growth
abroad. Strains in global financial markets have resurfaced in recent months, reflecting renewed
uncertainty about the resolution of the European situation. Risk premiums on sovereign debt and
other securities have risen again in many European countries, while European banks continue to
face pressure to shrink their balance sheets. Even without a further intensification of stresses, the
slowdown in economic activity in Europe will likely hold back U.S. export growth. Moreover,

-5 

the perceived risks surrounding the European situation are already having a meaningful effect on
financial conditions here in the United States, further weighing on the prospects for U.S. growth.
Given these formidable challenges, most private sector forecasters expect only gradual
improvement in the labor market and I share their view. Figure 2 shows the unemployment rate
together with the median forecast from last month’s Survey of Professional Forecasters (SPF),
the dashed blue line.3 The figure also shows the central tendency of the unemployment
projections that my FOMC colleagues and I made at our April meeting: Those projections reflect
our assessments of the economic outlook given our own individual judgments about the
appropriate path of monetary policy. Included in the figure as well is the central tendency of
FOMC participants’ estimates of the longer-run normal unemployment rate, which ranges from
5.2 percent to 6 percent. Like private forecasters, most FOMC participants expect the
unemployment rate to remain well above its longer-run normal value over the next several years.
Of course, considerable uncertainty attends this outlook: The shaded area provides an
estimate of the 70 percent confidence interval for the future path of the unemployment rate based
on historical experience and model simulations.4 Its width suggests that these projections could
be quite far off, in either direction. Nevertheless, the figure shows that labor market slack at
present is so large that even a very large and favorable forecast error would not change the
conclusion that slack will likely remain substantial for quite some time.
                                                            
3

The SPF released in May provides forecasts on a quarterly basis through mid-2013 and annual projections beyond
that date. To construct quarterly forecasts through the end of 2014, I interpolate the annual projections.
4
The forecast confidence interval is generated using stochastic simulations of the Federal Reserve staff’s FRB/US
model. Specifically, a baseline is constructed centered on the median of the SPF projections released in May, and
then the model is repeatedly simulated with shocks drawn from the set of historical disturbances experienced over
the period from 1968 to 2011. Similar estimates of forecast confidence intervals would be obtained if the intervals
were instead constructed using the actual historical forecast errors of private forecasters; for further discussion, see
table 2 of the FOMC’s Summary of Economic Projections, an addendum to the April Federal Open Market
Committee minutes, available at Board of Governors of the Federal Reserve System (2012), “Minutes of the Federal
Open Market Committee, April 24-25, 2012,” press release, May 16,
www.federalreserve.gov/newsevents/press/monetary/20120516a.htm.

-6 

Turning to inflation, figure 3 summarizes private and FOMC forecasts. Overall
consumer price inflation has fluctuated quite a bit in recent years, largely reflecting movements
in prices for oil and other commodities. In early 2011 and again earlier this year, prices of crude
oil, and thus of gasoline, rose noticeably. Smoothing through these fluctuations, inflation as
measured by the price index for personal consumption expenditures (PCE) averaged near 2
percent over the past two years. In recent weeks, however, oil and gasoline prices have
moderated and are now showing through to the headline inflation figures. Looking ahead, most
FOMC participants at the time of our April meeting expected inflation to be at, or a bit below,
our long-run objective of 2 percent through 2014; private forecasters on average also expect
inflation to be close to 2 percent. As with unemployment, uncertainty around the inflation
projection is substantial.
In the view of some observers, the stability of inflation in the face of high unemployment
in recent years constitutes evidence that much of the remaining unemployment is structural and
not cyclical. They reason that if there were truly substantial slack in the labor market, simple
accelerationist “Phillips curve” models would predict more noticeable downward pressure on
inflation. However, substantial cross-country evidence suggests that, in low-inflation
environments, inflation is notably less responsive to downward pressure from labor market slack
than it is when inflation is elevated. In other words, the short-run Phillips curve may flatten out.5
One important reason for this non-linearity, in my view, is downward nominal wage rigidity-that is, the reluctance or inability of many firms to cut nominal wages.
                                                            
The simplest accelerationist version of the Phillips curve relates the change in inflation to the level of labor market
slack; more-complicated versions also highlight the influence of inflation expectations, changes in marginal
production costs, and other factors. Evidence for the United States and other countries that the sensitivity of
inflation to resource slack may be nonlinear can be found in André Meier (2010), “Still Minding the Gap--Inflation
Dynamics during Episodes of Persistent Large Output Gaps,” IMF Working Paper WP/10/189 (Washington:
International Monetary Fund, August), www.imf.org/external/pubs/ft/wp/2010/wp10189.pdf.
5

-7 

The solid blue bars in figure 4 present a snapshot of the distribution of nominal wage
changes for individual jobs during the depth of the current labor market slump, based on data
collected by the Bureau of Labor Statistics.6 For comparison, the dashed red line presents a
hypothetical distribution of wage changes, using a normal distribution that approximates the
actual distribution of wage changes greater than zero. The distribution of actual wage changes
shows that a relatively high percentage of workers saw no change in their nominal wage, and
relatively few experienced modest wage cuts. This pile-up phenomenon at zero suggests that,
even when the unemployment rate was around 10 percent, many firms were reluctant to cut
nominal wage rates. In the absence of this barrier, nominal gains in wages and unit labor costs
would have likely been even more subdued given the severity of the economic downturn, with
the result that inflation would probably now be running at a lower rate.
Anchored inflation expectations are another reason why inflation has remained close to 2
percent in the face of very low resource utilization. As shown in figure 5, survey measures of
longer-horizon inflation expectations have remained nearly constant since the mid-1990s even as
actual inflation has fluctuated. As a result, the current slump has not generated the downward
spiral of falling expected and actual inflation that a simple accelerationist model of inflation
might have predicted. Indeed, keeping inflation expectations from declining has been an
important success of monetary policy over the past few years. At the same time, the fact that
longer-term inflation expectations have not risen above 2 percent has also proved extremely
                                                            
6

The data shown in figure 4 refer to the change in wages over the 12 months to March 2010. See Bruce Fallick,
Michael Lettau, and William Wascher (2011), “Downward Nominal Wage Rigidity in the United States during the
Great Recession,” unpublished manuscript, November. Similar results, based on a different source of data, are
reported in Mary Daly, Bart Hobijn, and Brian Lucking (2012), “Why Has Wage Growth Stayed Strong?” Federal
Reserve Bank of San Francisco, FRBSF Economic Letter 2012-10, April 2,
www.frbsf.org/publications/economics/letter/2012/el2012-10.html. I have explored the implications of downward
nominal rigidity for the Phillips curve and stabilization policy in greater depth in Janet L. Yellen and George A.
Akerlof (2006), “Stabilization Policy: A Reconsideration,” Economic Inquiry, vol. 44 (January), pp. 1-22.

-8 

valuable, for it has freed the FOMC to take strong actions to support the economic recovery
without greatly worrying that higher energy and commodity prices would become ingrained in
inflation and inflation expectations, as they did in the 1970s.
While my modal outlook calls for only a gradual reduction in labor market slack and a
stable pace of inflation near the FOMC’s longer-run objective of 2 percent, I see substantial risks
to this outlook, particularly to the downside. As I mentioned before, even without any political
gridlock, fiscal policy is bound to become substantially less accommodative from early 2013 on.
However, federal fiscal policy could turn even more restrictive if the Congress does not reach
agreement on several important tax and budget policy issues before the end of this year; in fact,
the CBO recently warned that the potential hit to gross domestic product (GDP) growth could be
sufficient to push the economy into recession in 2013.7 The deterioration of financial conditions
in Europe of late, coupled with notable declines in global equity markets, also serve as a
reminder that highly destabilizing outcomes cannot be ruled out. Finally, besides these clearly
identifiable sources of risk, there remains the broader issue that economic forecasters have
repeatedly overestimated the strength of the recovery and so still may be too optimistic about the
prospects that growth will strengthen.
Although I view the bulk of the increase in unemployment since 2007 as cyclical, I am
concerned that it could become a permanent problem if the recovery were to stall. In this
economic downturn, the fraction of the workforce unemployed for six months or more has
climbed much more than in previous recessions, and remains at a remarkably high level.
Continued high unemployment could wreak long-term damage by eroding the skills and labor
                                                            
See Congressional Budget Office (2012), Economic Effects of Reducing the Fiscal Restraint That Is Scheduled to
Occur in 2013 (Washington: CBO, May),
www.cbo.gov/sites/default/files/cbofiles/attachments/FiscalRestraint_0.pdf.
7

-9 

force attachment of workers suffering long-term unemployment, thereby turning what was
initially cyclical into structural unemployment. This risk provides another important reason to
support the recovery by maintaining a highly accommodative stance of monetary policy.
The Conduct of Policy with Unconventional Tools
Now turning to monetary policy, I will begin by discussing the FOMC’s reliance on
unconventional tools to address the disappointing pace of recovery. I will then elaborate my
rationale for supporting a highly accommodative policy stance.
As you know, since late 2008, the FOMC’s standard policy tool, the target federal funds
rate, has been maintained at the zero lower bound. To provide further accommodation, we have
employed two unconventional tools to support the recovery--extended forward guidance about
the future path of the federal funds rate, and large-scale asset purchases and other balance sheet
actions that have greatly increased the size and duration of the Federal Reserve’s portfolio.
These two tools have become increasingly important because the recovery from the
recession has turned out to be persistently slower than either the FOMC or private forecasters
anticipated. Figure 6 illustrates the magnitude of the disappointment by comparing Blue Chip
forecasts for real GDP growth made two years ago with ones made earlier this year. As shown
by the dashed blue line, private forecasters in early 2010 anticipated that real GDP would expand
at an average annual rate of just over 3 percent from 2010 through 2014. However, actual
growth in 2011 and early 2012 has turned out to be much weaker than expected, and, as
indicated by the dotted red line, private forecasters now anticipate only a modest acceleration in
real activity over the next few years.
In response to the evolving outlook, the FOMC has progressively added policy
accommodation using both of its unconventional tools. For example, since the federal funds rate

- 10  

target was brought down to a range of 0 to 1/4 percent in December 2008, the FOMC has
gradually adjusted its forward guidance about the anticipated future path of the federal funds
rate. In each meeting statement from March 2009 through June 2011, the Committee indicated
its expectation that economic conditions “are likely to warrant exceptionally low levels of the
federal funds rate for an extended period.”8 At the August 2011 meeting, the Committee decided
to provide more specific information about the likely time horizon by substituting the phrase “at
least through mid-2013” for the phrase “for an extended period”; at the January 2012 meeting,
this horizon was extended to “at least through late 2014.”9 Has this guidance worked? Figure 7
illustrates how dramatically forecasters’ expectations of future short-term interest rates have
changed. As the dashed blue line indicates, the Blue Chip consensus forecast made in early 2010
anticipated that the Treasury-bill rate would now stand at close to 3-1/2 percent; today, in
contrast, private forecasters expect short-term interest rates to remain very low in 2014.
Of course, much of this revision in interest rate projections would likely have occurred in
the absence of explicit forward guidance; given the deterioration in projections of real activity
due to the unanticipated persistence of headwinds, and the continued subdued outlook for
inflation, forecasters would naturally have anticipated a greater need for the FOMC to provide
continued monetary accommodation. However, I believe the changes over time in the language
of the FOMC statement, coupled with information provided by Chairman Bernanke and others in
speeches and congressional testimony, helped the public understand better the Committee’s
likely policy response given the slower-than-expected economic recovery. As a result,
                                                            
8

See, for example, Board of Governors of the Federal Reserve System (2009), “FOMC Statement,” press release,
March 18, www.federalreserve.gov/newsevents/press/monetary/20090318a.htm.
9
See Board of Governors of the Federal Reserve System (2011), “FOMC Statement,” press release, August 9,
www.federalreserve.gov/newsevents/press/monetary/20110809a.htm; and Board of Governors of the Federal
Reserve System (2012), “FOMC Statement,” press release, January 25,
www.federalreserve.gov/newsevents/press/monetary/20120125a.htm.

- 11  

forecasters and market participants appear to have marked down their expectations for future
short-term interest rates by more than they otherwise would have, thereby putting additional
downward pressure on long-term interest rates, improving broader financial conditions, and
lending support to aggregate demand.
The FOMC has also provided further monetary accommodation over time by altering the
size and composition of the Federal Reserve’s securities holdings, shown in figure 8. The
expansion in the volume of securities held by the Federal Reserve is shown in the left panel of
the figure. During 2009 and early 2010, the Federal Reserve purchased about $1.4 trillion in
agency mortgage-backed securities and agency debt securities and about $300 billion in longerterm Treasury securities. In November 2010, the Committee initiated an additional $600 billion
in purchases of longer-term Treasury securities, which were completed at the end of June of last
year. Last September, the FOMC decided to implement the “Maturity Extension Program,”
which affected the maturity composition of our Treasury holdings as shown in the right panel.
Through this program, the FOMC is extending the average maturity of its securities holdings by
selling $400 billion of Treasury securities with remaining maturities of 3 years or less and
purchasing an equivalent amount of Treasury securities with remaining maturities of 6 to 30
years. These transactions are currently scheduled to be completed at the end of this month.
Research by Federal Reserve staff and others suggests that our balance sheet operations
have had substantial effects on longer-term Treasury yields, principally by reducing term
premiums on longer-dated Treasury securities.10 Figure 9 provides an estimate, based on Federal
                                                            
10

The term premium on a longer-dated Treasury security is defined as the return that investors expect to earn on
holding this security in excess of the return from rolling over short-dated Treasury securities, such as three-month
Treasury bills. For estimates of the Federal Reserve’s balance sheet actions on long-term interest rates, see Canlin
Li and Min Wei (forthcoming), “Term Structure Modeling with Supply Factors and the Federal Reserve’s Large
Scale Asset Purchase Programs,” Finance and Economics Discussion Series (Washington: Board of Governors of
the Federal Reserve System); Joseph Gagnon, Matthew Raskin, Julie Remache, and Brian Sack (2010), “Large-

 

- 12  

Reserve Board staff calculations, of the cumulative reduction of the term premium on 10-year
Treasury securities from the three balance sheet programs. These results suggest that our
portfolio actions are currently keeping 10-year Treasury yields roughly 60 basis points lower
than they otherwise would be.11 Other evidence suggests that this downward pressure has had
favorable spillover effects on other financial markets, leading to lower long-term borrowing
costs for households and firms, higher equity valuations, and other improvements in financial
conditions that in turn have supported consumption, investment, and net exports. Because the
term premium effect depends on both the Federal Reserve’s current and expected future asset
holdings, most of this effect--without further actions--will likely wane over the next few years as

                                                                                                                                                                                               
 
Scale Asset Purchases by the Federal Reserve: Did they Work?” Staff Report no. 441 (New York: Federal Reserve
Bank of New York, March), www.ny.frb.org/research/staff_reports/sr441.html; Hess Chung, Jean-Philippe Laforte,
David Reifschneider, and John Williams (2012), “Have We Underestimated the Likelihood and Severity of Zero
Lower Bound Events?” supplement, Journal of Money, Credit and Banking, vol. 44 (S1, February), pp. 47-82;
Arvind Krishnamurthy and Annette Vissing-Jorgensen (2011), “The Effects of Quantitative Easing on Interest
Rates: Channels and Implications for Policy,” Brookings Papers on Economic Activity, Fall, pp. 215-65,
www.brookings.edu/about/projects/bpea/editions/fall-2011; and James Hamilton and Jing Cynthia Wu (2012), “The
Effectiveness of Alternative Monetary Policy Tools in a Zero Lower Bound Environment,” Journal of Money,
Credit and Banking, vol. 44, Issue Supplement s1 (February), pp. 3-46. Estimates of the effects of large-scale asset
purchases in the United Kingdom are provided in Michael Joyce, Matthew Tong, and Robert Woods (2011), “The
United Kingdom’s Quantitative Easing Policy: Design, Operation and Impact,” Bank of England Quarterly Bulletin,
Third Quarter, pp. 200-12.
11
The estimates shown in figure 9 employ the methodology discussed by Li and Wei, “Term Structure Modeling
with Supply Factors,” in note 10. These calculations require an assumption for market participants’ expectations for
the future path of the Federal Reserve’s portfolio at different points in time, both in the past and going forward;
accordingly, the estimates are somewhat sensitive to alternative assumptions for market expectations. In estimating
the current and future effect of the Federal Reserve’s securities holdings on term premiums, market participants are
assumed to have expectations consistent with the illustrative baseline discussed in note 16 and the exit principles
outlined by the FOMC in June 2011 (see note 18). In particular, investors are assumed to expect that the overall size
and composition of the portfolio will remain roughly constant from the end of 2012:Q2 through late 2014 because
principal payments on the Federal Reserve’s security holdings will be reinvested until a few months prior to the
liftoff of the federal funds rate assumed in the illustrative baseline. At that point, the portfolio is assumed to begin to
contract through redemptions and, after the assumed liftoff of the federal funds rate, through sales of mortgagebacked securities that bring the Federal Reserve’s holdings of such securities to zero over a three-to-five-year
period. As a result, the size of the portfolio returns to normal within a few years after liftoff.

- 13  

the effect depends less and less on the current elevated level of the balance sheet and
increasingly on the level of holdings during and after the normalization of our portfolio.12
The Rationale for Highly Accommodative Policy
I have already noted that, in my view, an extended period of highly accommodative
policy is necessary to combat the persistent headwinds to recovery. I will next explain how I’ve
reached this policy judgment. In evaluating the stance of policy, I find the prescriptions from
simple policy rules a logical starting point. A wide range of such rules has been examined in the
academic literature, the most famous of which is that proposed by John Taylor in his 1993
study.13 Rules of the general sort proposed by Taylor (1993) capture well our statutory mandate
to promote maximum employment and price stability by prescribing that the federal funds rate
should respond to the deviation of inflation from its longer-run goal and to the output gap, given
that the economy should be at or close to full employment when the output gap--the difference
between actual GDP and an estimate of potential output--is closed. Moreover, research suggests
that such simple rules can be reasonably robust to uncertainty about the true structure of the
economy, as they perform well in a variety of models.14 Today, I will consider the prescriptions
of two such benchmark rules--Taylor’s 1993 rule, and a variant that is twice as responsive to
economic slack. In my view, this latter rule is more consistent with the FOMC’s commitment to

                                                            
12

The term premium effect also wanes over time because the size of the effect depends on the expected difference
between the actual size of the balance sheet now and in the future and its normal size, where the latter is rising
steadily over time, primarily as a result of the trend growth in currency.
13
See John B. Taylor (1993), “Discretion versus Policy Rules in Practice,” Carnegie-Rochester Conference Series
on Public Policy, vol. 39 (December), pp. 195-214.
14
See the discussion in John B. Taylor and John C. Williams (2011), “Simple and Robust Rules for Monetary
Policy,” in Benjamin M. Friedman and Michael Woodford, eds., Handbook of Monetary Economics, vol. 3B (San
Diego: North Holland), pp. 829-60.

- 14  

follow a balanced approach to promoting our dual mandate, and so I will refer to it as the
“balanced-approach” rule.15
To show the prescriptions these rules would have called for at the April FOMC meeting, I
start with an illustrative baseline outlook constructed using the projections for unemployment,
inflation, and the federal funds rate that FOMC participants reported in April.16 I then employ
the dynamics of one of the Federal Reserve’s economic models, the FRB/US model, to solve for
the joint paths of these three variables if the short-term interest rate had instead been set
according to the Taylor (1993) rule or the balanced-approach rule, subject, in both cases, to the
zero lower bound constraint on the federal funds rate. The dashed red line in figure 10 shows the
resulting path for the federal funds rate under Taylor (1993) and the solid blue line with open
circles illustrates the corresponding path using the balanced-approach rule.17 In both
simulations, the private sector fully understands that monetary policy follows the particular rule
in force.18 Figure 10 shows that the Taylor rule calls for monetary policy to tighten immediately,
while the balanced-approach rule prescribes raising the federal funds rate in the fourth quarter of
                                                            
The balanced-approach rule is defined as Rt = 2 + πt + 0.5(πt - 2) + 1.0Yt. In this expression, R is the federal funds
rate, π is the percent change in the headline personal consumption expenditures price index from four quarters
earlier, and Y is the output gap. In a recent speech, I dubbed this rule “Taylor (1999),” as John Taylor described the
rule in a paper published that year. Since Taylor’s own strong preference is for his original rule--Taylor (1993)--I
now refer to the later rule as the “balanced-approach rule.”
16
The baseline paths for unemployment and inflation track the midpoint of the central tendency of the Committee’s
projections through 2014 and thereafter gradually converge to values consistent with participants’ long-run
projections. Similarly, the baseline path for the federal funds rate stays near zero through late 2014 and then rises
steadily back to the long-run value expected by most participants. While these assumptions are consistent with
recent FOMC statements, both the assumed date of liftoff and the longer-run pace of tightening are merely
illustrative and are not based on any internal FOMC deliberations. For further details on the construction of the
baseline, see Yellen, “The Economic Outlook and Monetary Policy,” in note 2.  
17
Because both rules respond to the output gap, the projections for the unemployment rate need to be converted into
a path for the output gap. The output gap is approximated using Okun’s law; specifically, Yt = 2.3(5.6-Ut), where
2.3 is the estimated value of the Okun’s law coefficient and 5.6 is the assumed value of the non-accelerating
inflation rate of unemployment, or NAIRU.
18
In the simulations, the Federal Reserve’s balance sheet is assumed to evolve in accordance with the exit strategy
principles that the FOMC agreed upon at the June 2011 meeting. See Board of Governors of the Federal Reserve
System (2011), “Minutes of the Federal Open Market Committee, June 21-22, 2011,” press release, July 12,
www.federalreserve.gov/newsevents/press/monetary/20110712a.htm.  
15

- 15  

2014--the earliest date consistent with the FOMC’s current forward guidance of “exceptionally
low levels for the federal funds rate at least through late 2014.”
Although simple rules provide a useful starting point in determining appropriate policy,
they by no means deserve the “last word”--especially in current circumstances. An alternative
approach, also illustrated in figure 10, is to compute an “optimal control” path for the federal
funds rate using an economic model--FRB/US, in this case. Such a path is chosen to minimize
the value of a specific “loss function” conditional on a baseline forecast of economic conditions.
The loss function attempts to quantify the social costs resulting from deviations of inflation from
the Committee’s longer-run goal and from deviations of unemployment from its longer-run
normal rate.19 The solid green line with dots in figure 10 shows the “optimal control” path for
the federal funds rate, again conditioned on the illustrative baseline outlook.20 This policy
involves keeping the federal funds rate close to zero until late 2015, four quarters longer than the
balanced-approach rule prescription and several years longer than the Taylor rule. Importantly,
optimal control calls for a later lift-off date even though this benchmark--unlike the simple
policy rules--implicitly takes full account of the additional stimulus to real activity and inflation

                                                            
19

Under this approach, the central bank’s plans are assumed to be completely transparent and credible to the public.
In particular, both the policymaker and private agents are assumed to act as if they have perfect foresight about the
evolution of the economy, including the future path of monetary policy, in that they ignore the possibility of
unanticipated future shocks to the economy. This assumption of “certainty equivalence” is commonly used but is
not an intrinsic feature of optimal control techniques. Indeed, the fully optimal policy under uncertainty involves the
specification of a complete set of state-contingent policy paths.
20
This procedure involves two steps. First, the FRB/US model’s projections of real activity, inflation, and interest
rates are adjusted to replicate the baseline forecast values. Second, a search procedure is used to solve for the path
of the federal funds rate that minimizes the value of an assumed loss function, allowing for feedback of changes in
the federal funds rate from baseline to real activity and inflation. For the purposes of the exercise, the loss function
is equal to the cumulative discounted sum from 2012:Q2 through 2025:Q4 of three factors--the squared deviation of
the unemployment rate from 5-1/2 percent, the squared deviation of overall PCE inflation from 2 percent, and the
squared quarterly change in the federal funds rate. The third term is added to damp quarter-to-quarter movements in
interest rates.

- 16  

being provided over time by the Federal Reserve’s other policy tool, the past and projected
changes to the size and maturity of its securities holdings.21
Figure 11 shows that, by keeping the federal funds rate at its current level for longer,
monetary policy under the balanced-approach rule achieves a more rapid reduction of the
unemployment rate than monetary policy under the Taylor (1993) rule does, while nonetheless
keeping inflation near 2 percent. But the improvement in labor market conditions is even more
notable under the optimal control path, even as inflation remains close to the FOMC’s long-run
inflation objective.
As I noted, simple rules have the advantage of delivering good policy outcomes across a
broad range of models, and are thereby relatively robust to our limited understanding of the
precise working of the economy--in contrast to optimal-control policies, whose prescriptions are
sensitive to the specification of the particular model used in the analysis. However, simple rules
also have their shortcomings, leading them to significantly understate the case for keeping policy
persistently accommodative in current circumstances.
One of these shortcomings is that the rules do not adjust for the constraints that the zero
lower bound has placed on conventional monetary policy since late 2008. A second is that they
do not fully take account of the protracted nature of the forces that have been restraining
aggregate demand in the aftermath of the housing bust. As I’ve emphasized, the pace of the
current recovery has turned out to be persistently slower than most observers expected, and
forecasters expect it to remain quite moderate by historical standards. The headwinds that
explain this disappointing performance represent a substantial departure from normal cyclical
                                                            
21

Optimal control takes account of the stimulus provided by the balance sheet operations because it conditions on a
baseline forecast of real activity and inflation that (at least implicitly) incorporates the effects of the Federal
Reserve’s balance sheet operations on projected financial conditions, real activity, and inflation.

- 17  

dynamics. As a result, the economy’s equilibrium real federal funds rate--that is, the rate that
would be consistent with full employment over the medium run--is probably well below its
historical average, which the intercept of simple policy rules is supposed to approximate. By
failing to fully adjust for this decline, the prescriptions of simple policy rules--which provide a
useful benchmark under normal circumstances--could be significantly too restrictive now and
could remain so for some time to come. In this regard, I think it is informative that the Blue
Chip consensus forecast released in March showed the real three-month Treasury bill rate
settling down at only 1-1/4 percent late in the decade, down 120 basis points from the long-run
projections made prior to the recession. 22
Looking Ahead
Recent labor market reports and financial developments serve as a reminder that the
economy remains vulnerable to setbacks. Indeed, the simulations I described above did not take
into account this new information. In our policy deliberations at the upcoming FOMC meeting
we will assess the effects of these developments on the economic forecast. If the Committee
were to judge that the recovery is unlikely to proceed at a satisfactory pace (for example, that the
forecast entails little or no improvement in the labor market over the next few years), or that the
downside risks to the outlook had become sufficiently great, or that inflation appeared to be in
danger of declining notably below its 2 percent objective, I am convinced that scope remains for
the FOMC to provide further policy accommodation either through its forward guidance or
through additional balance-sheet actions. In taking these decisions, however, we would need to
balance two considerations.
                                                            
22

For a further discussion of this issue, see William C. Dudley (2012), “Conducting Monetary Policy: Rules,
Learning and Risk Management,” speech delivered at the C. Peter McColough Series on International Economics,
Council on Foreign Relations, New York, May 24,
www.newyorkfed.org/newsevents/speeches/2012/dud120524.html.

- 18  

On the one hand, our unconventional tools have some limitations and costs. For
example, the effects of forward guidance are likely to be weaker the longer the horizon of the
guidance, implying that it may be difficult to provide much more stimulus through this channel.
As for our balance sheet operations, although we have now acquired some experience with this
tool, there is still considerable uncertainty about its likely economic effects. Moreover, some
have expressed concern that a substantial further expansion of the balance sheet could interfere
with the Fed’s ability to execute a smooth exit from its accommodative policies at the
appropriate time. I disagree with this view: The FOMC has tested a variety of tools to ensure
that we will be able to raise short-term interest rates when needed while gradually returning the
portfolio to a more normal size and composition. But even if unjustified, such concerns could in
theory reduce confidence in the Federal Reserve and so lead to an undesired increase in inflation
expectations.
On the other hand, risk management considerations arising from today’s unusual
circumstances strengthen the case for additional accommodation beyond that called for by simple
policy rules and optimal control under the modal outlook. In particular, as I have noted, there are
a number of significant downside risks to the economic outlook, and hence it may well be
appropriate to insure against adverse shocks that could push the economy into territory where a
self-reinforcing downward spiral of economic weakness would be difficult to arrest.
Conclusion
In my remarks this evening I have sought to explain why, in my view, a highly
accommodative monetary policy will remain appropriate for some time to come. My views
concerning the stance of monetary policy reflect the FOMC’s firm commitment to the goals of
maximum employment and stable prices, my appraisal of the medium term outlook (which is

- 19  

importantly shaped by the persistent legacy of the housing bust and ensuing financial crisis), and
by my assessment of the balance of risks facing the economy. Of course, as I’ve emphasized, the
outlook is uncertain and the Committee will need to adjust policy as appropriate as actual
conditions unfold. For this reason, the FOMC’s forward guidance is explicitly conditioned on its
anticipation of “low rates of resource utilization and a subdued outlook for inflation over the
medium run.”23 If the recovery were to proceed faster than expected or if inflation pressures
were to pick up materially, the FOMC could adjust policy by bringing forward the expected date
of tightening. In contrast, if the Committee judges that the recovery is proceeding at an
insufficient pace, we could undertake portfolio actions such as additional asset purchases or a
further maturity extension program. It is for this reason that the FOMC emphasized, in its
statement following the April meeting, that it would “regularly review the size and composition
of its securities holdings and is prepared to adjust those holdings as appropriate to promote a
stronger economic recovery in a context of price stability.”24

                                                            
23

See Board of Governors, “FOMC Statement,” January 25, in note 9. 
See Board of Governors of the Federal Reserve System (2012), “FOMC Statement,” press release, April 25,
www.federalreserve.gov/newsevents/press/monetary/20120425a.htm. 

24

Perspectives on
Monetary Policy
Janet L. Yellen
Vice Chair
Board of Governors of the Federal Reserve
System
Boston Economic Club
June 6, 2012

Economy is expanding at a moderate pace
• Unemployment has declined over the past
year.
• But we remain far short of full employment.
• Further progress is likely to be gradual due to
persistent headwinds.
• I expect inflation at or below 2% for the
foreseeable future.
2

• Risks are tilted toward a weaker economy.
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3

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Headwinds to recovery
• Housing sector
• Fiscal policy
• Sluggish pace of growth abroad and global
financial market strains
4

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5

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6

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Behavior of Inflation and Unemployment
• Does the stability of inflation in the face of high
unemployment mean that unemployment is
structural, not cyclical?
• Simple Phillips curve model predicts downward
pressure on inflation from labor market slack.
• But cross country evidence shows that once
inflation is low, it is less responsive to slack.
• This nonlinearity may reflect downward
nominal wage rigidity.
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7

8

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9

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Downside risks to the outlook
• Impending “fiscal cliff”
• Potential for highly destabilizing developments in
Europe and global financial markets.
• Forecasters have repeatedly overestimated the
strength of the recovery and may still be too
optimistic.
• Potential for cyclical unemployment to become
structural if the recovery were to stall.
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11

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12

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13

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14

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15

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16

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Simple Rules may understate the case
for keeping policy accommodative
• Rules don’t adjust for a long period of policy
restraint due to the zero lower bound.
• Rules ignore the persistent headwinds that
have been holding back recovery.
– These headwinds imply an abnormally low
equilibrium real funds rate.
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17

Looking ahead
• Economy remains vulnerable to setbacks.
• Scope remains for the FOMC to provide
further policy accommodation.
– Unconventional tools have some limits and costs.

• If Committee judges that the recovery is
proceeding at an insufficient case could:
– Extend Maturity Extension Program
– Undertake additional asset purchases
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18