FRBSF Economic Letter
98-38; December 25, 1998
Describing Fed Behavior
Describing the reasons for the policy actions of the Federal Reserve
has long been a popular topic for economists, economic journalists, investors,
and others. In particular, there is keen interest in what economists call
the Fed's implied "reaction function," which models how the Fed sets monetary
policy in response to conditions in the economy. This interest is not
surprising given that the reaction function can provide insight into possible
future changes in the stance of Fed policy. Also, within the context of
a model of the economy, a reaction function provides a basis for evaluating
monetary policy (as in Rudebusch and Svensson 1998), as well as for understanding
the effects of other policies (for example, fiscal policy) or economic
shocks (for example, the 1970s oil embargo) that may induce a monetary
policy response. In this Letter, we summarize the results of
our research paper--Judd and Rudebusch 1998--which provides estimates
of a Fed reaction function.
Large numbers of Fed reaction functions have been estimated by economists.
But despite this work, researchers have not been particularly successful
in providing a definitive representation of Fed behavior (see Rudebusch
1998). In part, this lack of success stems from the fact that the Fed's
specific response to certain economic situations seems to change over
time.
One factor that may be associated with changes in the Fed's reaction
function over time is changes in the composition of the policymaking body--the
Federal Open Market Committee (FOMC). Such compositional changes may bring
to the fore policymakers with different preferences and different conceptions
of the appropriate operation and the likely transmission of monetary policy.
While many people and events influence policy, arguably one of the more
important and identifiable compositional changes is in the Fed
Chairmanship.
In this Letter, we use the Taylor rule as a tool for characterizing
Fed policy. In essence, the rule describes a policy regime in which the
Fed sets the real (inflation-adjusted) funds rate with an eye toward controlling
inflation and stabilizing the business cycle. Thus the rule focuses on
the variables of primary interest to the Fed. We examine whether the rule
is capable of capturing the broad differences in how policy was conducted
during the tenures of Fed Chairmen Greenspan, Volcker, and Burns.
Taylor Rule
Taylor (1993) suggested a very specific and simple rule for monetary
policy. It sets the level of the real funds rate equal to an "equilibrium"
real funds rate (a benchmark for neutral policy that is consistent with
full employment) plus a weighted average of two gaps: (1) recent inflation
less a target rate, and (2) the (percent) deviation of real GDP from an
estimate of its potential, or full-employment, level.
Taylor assumed that the equilibrium real interest rate and the inflation
target were both equal to 2%, and that the weights the Fed gave to deviations
of inflation and output were both equal to ½. Thus, for example, if inflation
were 1 percentage point above its target and output were at its potential
level, the rule would recommend a funds rate of 5½% (3% for inflation
plus 2% for the equilibrium real funds rate plus ½% for the excess of
inflation over its target).
This rule is consistent with a policy regime in which the Fed attempts
to control inflation in the long run and to smooth the amplitude of the
business cycle in the short run. The arguments in the rule--inflation
and the GDP gap--roughly correspond with goals legislated for U.S. monetary
policy, namely, stable prices and full employment. In this spirit, Governor
Meyer (1998) stresses that stabilizing real GDP around its trend in the
short run and controlling inflation in the longer term are important concerns
of the Fed. Although U.S. policymakers look at many economic and financial
indicators, the two gaps specified in the rule may be stylized measures
of their ultimate goals.
Moreover, the GDP gap can be interpreted not only as a measure of business
cycle conditions but also as an indicator of future inflation in the context
of a Phillips curve model. The productive capacity of the U.S. economy,
whether measured by potential GDP, industrial capacity, or the "natural"
rate of unemployment, appears to figure prominently in Fed forecasts of
future inflation.
In contrast to the Taylor rule, most empirical reaction functions suggest
that the Fed responds both to the broad measures of economic performance
that are of ultimate interest for policy, such as output and inflation,
as well as to so-called intermediate variables, which are not of direct
interest to the Fed but may affect or predict the ultimate goal variables.
Examples of such intermediate variables include the monetary aggregates,
exchange rates, the budget deficit, and commodity prices. However, Fed
responses to these intermediate variables are especially likely to change
over time because their relationship to the ultimate goal variables may
shift.
For example, the monetary aggregates played a more direct role in policy
formulation in the 1970s and especially the early 1980s than they do now.
Even when the Fed was explicitly targeting the aggregates, it was not
ultimately interested in them per se, but instead cared about how the
aggregates affected economic performance.
By focusing on the ultimate goals of policy, the Taylor rule may be capable
of capturing Fed reactions in a consistent way during periods when the
Fed actively targeted money and when it did not. More generally, by eliminating
intermediate variables and focusing only on a few basic goal variables,
the Taylor rule may be able to avoid some of the instability plaguing
previous Fed reaction functions.
Findings
Taylor (1993) showed that his rule does a reasonable job of describing
the actual funds rate under Chairman Greenspan. The rule also provides
some perspective on policies under Chairmen Burns and Volcker (Judd and
Trehan 1995). With regard to the Burns period, the actual funds rate consistently
was lower than the rule's recommended rate, which accords with the overall
increase in inflation during this period. During the Volcker period, when
the Fed significantly reduced inflation, the actual funds rate was consistently
higher than what the rule recommended.
But while the original Taylor rule provides a reasonable starting point,
it is useful to examine alternatives to Taylor's simple specification
by estimating the reaction function weights using the historical record,
rather than simply assuming weights as Taylor did. Estimating Taylor-type
equations may provide a different or better description of Fed policy.
In this Letter, we can only summarize our results. The details
of the empirical analysis can be seen in Judd and Rudebusch (1998).
One complication in estimating the Taylor rule is that central banks
often appear to adjust interest rates in a gradual fashion--taking small
steps toward a desired setting. We allow for such interest rate smoothing
by estimating the Taylor rule in the context of a so-called error-correction
model. This approach allows for the possibility that the funds rate adjusts
gradually to achieve the rate recommended by the rule. In fact,
such interest rate smoothing is apparent in the regression results for
the entire period examined from 1970 to the present.
The estimated Taylor rule for Chairman Greenspan's tenure (1987 to the
present) fits the data quite well. The estimated equation explains two-thirds
of the quarterly variation in the funds rate during this period. The estimated
weight on inflation of 0.54 is very close to what Taylor (1993) assumed
(0.5), while the estimated coefficient on the GDP gap of 0.99 is higher
than Taylor assumed (0.5). Finally, the data suggest that the equilibrium
funds rate and the inflation target both fall in a range of 1¾ to
2¾%--not far from Taylor's assumption of 2%.
The estimation for the period during which Paul Volcker was Chairman
(1979 to 1987) similarly finds evidence that policy was concerned with
both the rate of inflation relative to a target and the growth rate of
real GDP relative to the growth rate of potential GDP. The coefficient
on the inflation gap is again very close to the 0.5 assumed by Taylor,
while the response to output growth is 1.5.
However, the equation is estimated for this period with much less precision
than for the Greenspan period. For example, the equation explains only
slightly less than one-half of the quarterly variation in the funds rate
compared with two-thirds for Greenspan. In part, this could be because
the problem facing policy in 1979 was so clear. The double-digit inflation
prevailing at the time was so far above any reasonable inflation target
that policy did not need to be as concerned with the rather refined judgments
about funds rate settings provided by a Taylor-style reaction function.
Instead, policy could simply keep the real funds rate at a "high" level
until inflation began to come down.
A key feature of the reaction function for Chairman Burns's tenure (1970
to 1978) is the clear insignificance of the coefficient on the inflation
gap. Instead, the funds rate responded only to the GDP gap. The lack of
an implicit or explicit inflation target is consistent with the large
increase in inflation during this period.
Of course, other factors may have played a role as well. In particular,
there were two large oil shocks that added substantially to the price
leve
In addition, the output gap may have been underestimated during this
period. The existence of such a mistake has been given an important role
during the period by many analysts. Such a consistent string of mistakes
would not be too surprising. During this period, productivity and potential
output both exhibited a surprising slowdown in growth, a development which
is still largely unexplained by economists. At the same time, demographic
factors, especially the entrance of the baby boom generation into the
labor force, created an increase in the natural rate of unemployment that
also was unexpected. Indeed, there was a widespread view that an unemployment
rate of 4% was a suitable benchmark rate for policy. In contrast, recent
(time-varying) estimates of the natural rate that prevailed during this
period are in the 6 to 6½% range (e.g., Gordon 1997). Both of these factors--an
underestimate of the GDP gap and the natural rate of unemployment--could
have contributed to unduly easy policy, since it may have appeared at
the time that inflationary pressures were less severe than they really
were.
Conclusion
Overall, our analysis finds that the Taylor rule--which describes policy
in terms of the Fed's basic goal variables--is a useful framework for
summarizing key elements of monetary policy. Estimates of this equation
confirm that while inflation was not a key variable guiding policy in
the 1970s, policy has focused on controlling inflation and smoothing the
business cycle in the 1980s and 1990s.
John P. Judd
Vice President and
Associate Director of Research
Glenn D. Rudebusch
Research Officer
References
Gordon, Robert. 1997. "The Time-Varying NAIRU and Its Implications for
Economic Policy." Journal of Economic Perspectives 11 (Winter)
pp. 11-32.
Judd, John P., and Bharat Trehan. 1995. "Has the Fed Gotten Tougher
on Inflation?" FRBSF Weekly Letter 95-13 (March 31).
_____, and Glenn D. Rudebusch. 1998. "Taylor's
Rule and the Fed: 1970-1997." Federal Reserve Bank of San Francisco
Economic Review 3, pp. 1-16.
Meyer, Laurence H. 1998. "The Strategy of Monetary Policy." The Alan
R. Holmes Lecture, Middlebury College, Middlebury, Vermont (March 16).
Rudebusch, Glenn D. 1998. "Do Measures of Monetary Policy Shocks in
a VAR Make Sense?" International Economic Review 39, pp. 907-931.
_____, and Lars E.O. Svensson. 1998. "Policy Rules for Inflation Targeting."
NBER Working Paper 6512.
Taylor, John B. 1993. "Discretion Versus Policy Rules in Practice." Carnegie-Rochester
Conference Series on Public Policy 39, pp. 195-214.
Opinions expressed in this newsletter do not necessarily reflect
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or of the Board of Governors of the Federal Reserve System. Editorial
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