What are the rationales for using a fixed money supply rule, rules
employing feedback mechanisms, or allowing policy makers discretion when
setting monetary policy? Where does the Taylor Rule fit in this discussion?
Several of you share the credit this month for asking about monetary
policy rules. However, the real credit for this answer goes to Prof. Carl
E. Walsh, a visiting scholar at the Federal Reserve Bank of San Francisco
and Professor of Economics at U.C. Santa Cruz. His article, "The
Science (and Art) of Monetary Policy," FRBSF Economic Letter,
Number 2001-13, May 4, 2001, does a great job of addressing the fine line
between the art and science of monetary policy. You may link to his complete
article at: http://www.frbsf.org/publications/economics/letter/2001/el2001-13.html
or review a condensed version below:
Excerpted from, "The Science (and Art) of Monetary Policy,"
by Carl E. Walsh.
Are there rules for designing and implementing good monetary
policy that all economists agree on? Or is policymaking inherently a subjective
task, one that depends critically on combining both good economics and
Is monetary policy a science?
Currently, many economists are in agreement with three
basic principles that form the core of the "scientific" approach to monetary
policy. Each of these principles is designed to guide central bankers.
Principle 1: Focus on the output gap. A huge
literature in the 1980s and 1990s showed how excessive inflation can result
if a central bank aims for output objectives that are too ambitious. If,
for example, the central bank engages in expansionary policies in an attempt
to keep output above potential, the net result will only be a higher average
rate of inflation.
Many solutions to this problem have been suggested. The
simplest is to have the central bank adopt a realistic output objective.
Specifically, the central bank should strive to stabilize output around
potential output, sometimes also called full-employment output.
Principle 2: Follow the Taylor Principle. The
second principle in the "scientific" approach to monetary policy is to
follow the Taylor Principle. This principle states that the central bank's
policy interest rate should be increased more than one for one with increases
in the inflation rate. Named after Stanford University economist John
Taylor, the Taylor Principle ensures that an increase in the inflation
rate produces a policy reaction that increases the real rate of interest—the
interest rate corrected for inflation. The rise in the real interest rate
reduces private spending, slows the economy down, and brings inflation
back to the central bank's inflation target. Conversely, if inflation
falls below the central bank's target, the Taylor Principle calls for
a more than one for one cut in the central bank's policy interest rate.
This reduces the real rate of interest, stimulates private spending, and
pushes inflation back to its target level.
Policies that violate the Taylor Principle can lead to
serious problems. If a rise in inflation is met by a less than one for
one increase in the policy rate, then real interest rates actually fall.
This fuels further economic expansion, pushing inflation even higher.
Rather than acting to bring inflation back down to its target level, such
a policy can cause inflation to spiral out of control.
One way to implement the Taylor Principle is to follow
a Taylor Rule, also named after John Taylor, which specifies exactly how
much to change the federal funds rate in response to changes in inflation
and the output gap.
Principle 3: Be forward-looking. Monetary policy
actions affect the economy with a lag. An interest rate cut may not have
its maximum impact on real output for twelve or even eighteen months,
and the effects on inflation may take longer still. Central banks cannot
wait to act until inflation has increased or the economy has gone into
a recession. These lags mean that central banks must be forward-looking.
For example, when the Fed raised interest rates in 2000, inflation was
still quite low, once the volatile food and energy components were removed.
The Fed acted because it was concerned that inflation would otherwise
begin to rise.
One policy framework that satisfies these three principles
is inflation forecast targeting. Under an inflation forecast targeting
procedure, the central bank is concerned with stabilizing inflation at
low levels and with stabilizing the output gap. Because of the lags in
policy, the emphasis is on responding to the central bank's forecast of
future inflation. If the forecast says inflation will rise, the central
bank should act to slow the economy down—it doesn't wait until inflation
actually has increased. Because inflation forecast targeting is based
on the three policy principles, it has gained many adherents among academic
and central bank economists.
Is there more to achieving good monetary policies than
simply following the economist's scientific principles?
Is monetary policy an art?
Perhaps the public believes Alan Greenspan's leadership
matters because it perceives monetary policy to be, in part, an art. It
requires the fine touch of a master policymaker, one whose feel for the
correct moment to change interest rates cannot be reduced to a few scientific
principles. But if making policy isn't a science, what exactly is nonscientific
about it? The best way to understand the "art" of policymaking is to revisit
our three policy principles.
How can we focus on the output gap when we don't
know what it is? It's all very well to tell central banks to focus
on the output gap, but how are they supposed to know what the gap is?
When major shifts in productivity growth occur—as happened in the 1970s
with the productivity slowdown and again in the 1990s with the productivity
speedup, measuring the output gap can be difficult. The output gap is
the difference between something we can measure (real GDP) and something
we can't (the economy's potential output level).
Implementing the Taylor Principle. The Taylor
Principle calls for adjusting the policy interest rate more than one for
one with changes in inflation. But how much more? If inflation rises by
1 percentage point, should the federal funds rate be increased by 1.5
percentage points? 2 percentage points? Or 1.01 percentage points? The
Taylor Principle alone does not offer guidance.
The art of forecasting. Implementing inflation
forecast targeting means the central bank has to be able to forecast future
economic conditions. This is not an easy task. Last summer, economic forecasts
did not foresee the growth slowdown that began during the third quarter.
The Fed had to respond quickly in early 2001 as signs of an economic slowdown
Good forecasts are based on good data, good economic
models, and good judgment. Mechanical forecasts based on a few key indicators
inevitably ignore information that might be relevant. While statistical
models provide a baseline for developing economic forecasts, good forecasters
always supplement the models' predictions with judgmental adjustment.
Economists have contributed much to making the design
of monetary policy more scientific. From the articulation of general principles
for good policy to the construction of small models that can be used to
simulate the impacts of alternative policies, recent research by academic
and central bank economists has contributed to our knowledge about monetary
policy. Despite these advances, however, conducting policy is far from
routine. General principles are important, but they're not sufficient—policymakers
also need quantifiable guidance. They need to know whether the current
output gap is +2% or -2%. They need to know whether the funds rate should
be increased by 150 basis points or 200 for every 1 percentage point rise
in inflation. And they need to know how much inflation will rise or fall
over the next six months. This level of guidance is still missing from
the science of monetary policy. The art of conducting policy lies in the
ability to translate the general principles into actual policy decisions.
There is a long tradition of trying to take discretion
out of monetary policy—Milton Friedman's proposal that the Fed should
just ensure a constant annual growth rate for the money supply was an
example of a policy designed to remove the role of the individual policymaker.
While economists have identified broad principles to guide policymakers,
making policy is not a science. Good policy will probably always require
good policymakers, as it requires combining the science of the economist
with the art of the practitioner.
Carl E. Walsh
Professor of Economics, UC Santa Cruz,
and Visiting Scholar, FRBSF
Clarida, Richard, Jordi Gali, and Mark Gertler. 1999. "The
Science of Monetary Policy: A New Keynesian Perspective." Journal of
Economic Literature 37 (December) pp. 1,661-1,707.
Svensson, Lars E. O. 1999. "How Should Monetary Policy Be Conducted
in an Era of Price Stability?" In New Challenges for Monetary Policy,
pp. 195-259. Federal Reserve Bank of Kansas City.
For additional information on the Taylor Rule:
Dr. Econ, "What is Taylor's rule?" March 1998, provides a description
of the Taylor Rule. http://www.frbsf.org/education/activities/drecon/9803.html
Hetzel, Robert L. 2000. "The Taylor Rule: Is It a Useful Guide to
Understanding Monetary Policy?" Federal Reserve Bank of Richmond,
Economic Quarterly, Spring 2000, p. 1-33. http://www.rich.frb.org/pubs/eq/pdfs/spring2000/hetzel.pdf
Judd, John P., and Glenn D. Rudebusch. 1998. "Taylor's Rule and
the Fed, 1970-1997." Federal Reserve Bank of San Francisco, Economic
Review. No. 3. 1998, p. 3-16. http://www.sf.frb.org/econrsrch/econrev/98-3/3-16.pdf
Monetary Trends, May 2001, Federal Reserve Bank of St. Louis,
provides an illustration of the federal funds rate and inflation targets
over time. See chart titled: Federal Funds Rate and Inflation Targets,
on page 10, Policy Based Inflation Indicators. http://www.stls.frb.org/docs/publications/mt/mt.pdf