Board of Governors of the Federal Reserve System

Policy Rules and How Policymakers Use Them

Alternative policy rules
While the Taylor rule is the best-known formula that prescribes how policymakers should set and adjust the short-term policy rate in response to the values of a few key economic variables, many alternatives have been proposed and analyzed.

The table below reports five policy rules that are illustrative of the many rules that have received attention in the academic research literature.¹

All of the rules in the table prescribe a level for the policy rate that is related to the deviation of inflation from the central bank's objective--2 percent in the United States. The first four rules also respond to the percentage difference between the current value of real gross domestic product (GDP) and potential GDP. These rules differ in terms of how strongly the prescribed policy rate reacts to the inflation and resource utilization gaps. The third rule recognizes that there is an effective lower bound (ELB) on the policy rate; in practice, central banks have judged that the ELB is close to zero.² This rule tracks the balanced-approach rule during normal times, but after a period during which the balanced-approach rule prescribes setting the policy rate below the ELB, the ELB-adjusted rule keeps the policy rate low for a long enough time to make up for the past shortfall in accommodation. The fourth and fifth rules differ from the other rules in that they relate the current policy prescription to the level of the policy rate in the previous period. The final rule responds to the change in real GDP rather than the percentage deviation of real GDP from potential GDP.

A detailed discussion of the Taylor rule formula is provided in Principles for the Conduct of Monetary Policy. The balanced-approach rule is similar to the Taylor rule except that the coefficient on the resource utilization gap is twice as large as in the Taylor rule.³ Thus, this rule puts more weight on stabilizing that gap than does the Taylor rule--a distinction that becomes especially important in situations in which there is a conflict between inflation stabilization and output-gap stabilization. An example is when inflation is above the 2 percent objective by the same amount that output is below its full resource utilization level. In this situation, the balanced-approach rule prescribes a lower federal funds rate than the Taylor rule because the balanced-approach rule places a higher weight on providing the monetary stimulus necessary to raise the level of output up to its full resource utilization level.

When inflation is running well below 2 percent and there is substantial slack in resource utilization, some policy rules prescribe setting the federal funds rate materially below zero; doing so is not feasible. The ELB-adjusted rule recognizes this constraint and thus prescribes setting the policy rate at the ELB whenever the balanced-approach rule prescribes a rate below the ELB. The term $$ Z_t$$ measures the cumulative shortfall in monetary stimulus that occurs because short-term interest rates cannot be reduced below the ELB. Compared with the balanced-approach rule, the ELB-adjusted rule would leave the federal funds rate lower for a longer period of time following an episode when the balanced-approach rule would prescribe policy rates below the ELB.

The inertial rule prescribes a response of the federal funds rate to economic developments that is spread out over time. For example, the response to a persistent upside surprise to inflation would gradually build over time, and the federal funds rate would ultimately rise to the same level as under the balanced-approach rule.⁴ This kind of gradual adjustment is a feature often incorporated into policy rules; it damps volatility in short-term interest rates. Some authors have argued that such gradualism describes how the Federal Reserve has implemented adjustments to the federal funds rate historically or how inertial behavior can be advantageous--for example, because it allows stabilizing the economy with less short-term interest rate volatility.⁵

The first-difference rule, like the inertial rule, relates the current value of the federal funds rate to its previous value. One feature of this rule is that it does not require information about the value of the neutral real policy rate in the longer run or about the level of output at full resource utilization. Instead, under the first-difference rule, the prescribed change in the federal funds rate depends only on inflation and output growth.⁶ Advocates of this rule emphasize that both the neutral real federal funds rate in the longer run and the level of GDP associated with full resource utilization are unobserved variables that likely vary over time and are estimated with considerable uncertainty. In light of these difficulties, they prefer rules like the first-difference rule in which the prescriptions for the change in the federal funds rate do not depend on estimates of unobserved variables.⁷ Moreover, these advocates have emphasized that the first-difference rule, similar to the other rules, stabilizes economic fluctuations so that inflation converges to its objective over time and output converges to a level consistent with full resource utilization. This feature reflects that the first-difference rule satisfies the key principles of good monetary policy discussed in Principles for the Conduct of Monetary Policy; in particular, it calls for the policy rate to rise over time more than one-for-one in response to a sustained increase in inflation.

Fed policymakers consult, but do not mechanically follow, policy rules
Policy rules provide useful benchmarks for setting and assessing the stance of monetary policy. Well-specified rules are appealing because they incorporate the key principles of good monetary policy discussed in Principles for the Conduct of Monetary Policy, but they nevertheless have shortcomings.

In deciding how to set monetary policy, the Federal Open Market Committee (FOMC) regularly consults the policy prescriptions from several monetary policy rules along with other information that is relevant to the economy and the economic outlook.⁸ Because of the small number of variables in these rules, the rules are easy to interpret and they provide a starting point for thinking about the implications of incoming information for the level of the federal funds rate. Despite their apparent simplicity, these rules raise a number of issues if they were to be used to implement monetary policy. If policymakers wanted to follow a policy rule strictly, they would have to determine which measure of inflation should be used (for example, they could choose the rate at which the consumer price index is rising, the growth rate of the price index for personal consumption expenditures, inflation measures net of food and energy price inflation, or even measures of wage inflation) and which measure of economic activity should be used (for example, output relative to its level at full resource utilization, the deviation of the unemployment rate from its longer-run average level, or the growth rates of these variables). The value of the neutral real federal funds rate in the longer run would need to be determined, and policymakers would need to decide whether that rate is varying over time and, if so, in what manner .

The U.S. economy is highly complex, however, and monetary policy rules, by their nature, do not capture that complexity. This complexity reflects in part the ever-changing nature of the U.S. economy in response to a variety of factors that lead to resource reallocations across sectors. (Such factors include demographic developments, new technologies, and other shifts that occur over time and are not related to monetary policy.) These changes in the economy make it difficult to accurately measure variables that are important determinants of the rules--such as potential output, the natural rate of unemployment, and the neutral real federal funds rate in the longer run--as well as to disentangle the effects of permanent and transitory changes on the economy. Consequently, the FOMC examines a great deal of information to assess how realized and expected economic conditions are evolving relative to the objectives of maximum employment and 2 percent inflation. As discussed in Challenges Associated with Using Rules to Make Monetary Policy, there are important limitations that argue against mechanically following any rule.

Because the U.S. economy is complex and the understanding of it is incomplete, Fed policymakers have a diversity of views about some of the details of how monetary policy works and how the federal funds rate should be adjusted to most effectively promote maximum employment and price stability. These differing views are reflected in the economics profession more generally and in alternative formulations of policy rules.

As shown in figure 1, historical prescriptions from policy rules differ from one another and also differ from the actual level of the federal funds rate (the black solid line).⁹ Although the prescriptions of the five rules tend to move up and down together over time, there can be significant differences in the levels of the federal funds rate that these rules prescribe. The prescriptions of the inertial rule and the first-difference rule typically call for more gradual adjustments of the federal funds rate than the prescriptions from the Taylor rule and the balanced-approach rule.

Figure 1 also shows that all of the rules called for a significant reduction in the federal funds rate in 2008, when the U.S. economy deteriorated substantially during the Global Financial Crisis. In addition, all of the rules, except for the ELB-adjusted rule, called for values of the policy rate that were below the ELB in 2009.¹⁰ The rates prescribed by the balanced-approach rule were substantially below zero, reflecting the appreciable shortfalls in real GDP from its full resource utilization level in 2009 and 2010 and this rule's large coefficient on those deviations. As the economy recovered and real GDP moved back toward its potential level, the prescriptions given by the Taylor and the balanced-approach rules rose and moved well above zero by 2015. However, the prescriptions of the inertial and first-difference rules increased more gradually in response to the improvement in economic conditions, and they remained persistently low for several years after 2009.

The large discrepancies between the actual federal funds rate and the prescriptions given by the Taylor rule and the balanced-approach rule suggest that economic outcomes likely would have been significantly different had monetary policy followed one of these rules. To address questions such as these, economists use models of the U.S. economy designed to evaluate the implications of alternative monetary policies. However, these models are invariably simplifications of reality, and there is no agreed-upon "best" model representation of the U.S. economy. Without wide agreement on the metric for evaluating alternative policy rules, there remains considerable debate among economists regarding the merits and shortcomings of the various rules.

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