NEW YORK (MNI) – The following is the fourth of seven sections of
Federal Reserve Vice Chair Janet Yellen’s text and footnotes prepared
Wednesday for the Money Marketeers of New York University:
To show what an optimal control approach might have called for at
the time of the January FOMC meeting, figure 7 depicts a purely
illustrative baseline outlook constructed using the distribution of FOMC
participants projections for unemployment, inflation, and the federal
funds rate that we published in January. Here, the baseline paths for
unemployment and inflation track the midpoint of the central tendency of
the Committees projections through 2014. The unemployment rate
gradually converges to around 5-1/2 percent — roughly the midpoint of
the central tendency of participants long-run projections of these
factors — and inflation converges to the Committees longer-run goal of
2 percent. The baseline path for the funds rate stays near zero through
late 2014 and then rises steadily back to the long-run value expected by
most participants. While this path is consistent with the January and
March statements, I hasten to add that 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.10 Given this baseline, one
can then employ the dynamics of one of the Federal Reserves economic
models, the FRB/US model, to solve for the optimal funds rate path
subject to a particular loss function.11 Such a policy involves keeping
the funds rate close to zero until late 2015. This highly accommodative
policy path generates, according to the FRB/US model, a notably faster
reduction in unemployment than in the baseline outlook. In addition, the
inflation rate runs close to the FOMCs longer-run goal of 2 percent
over coming years. According to the specified loss function, and in my
opinion, this economic outcome would be more desirable than the
baseline.
One reason this exercise generates a better outcome is because it
assumes that the Federal Reserves inflation objective is fully
credible–that is, all households and businesses fully understand the
Federal Reserves goals and believe that policymakers will follow the
optimal policy designed to meet those goals. This belief ties down
longer-term inflation expectations in the model even while it allows the
lower interest rate to spur faster growth in output and employment.
While optimal control exercises can be informative, such analyses hinge
on the selection of a specific macroeconomic model as well as a set of
simplifying assumptions that may be quite unrealistic. I therefore
consider it imprudent to place too much weight on the policy
prescriptions obtained from these methods, so I simultaneously consider
other approaches for gauging the appropriate stance of monetary policy.
Alternative Benchmarks for Monetary Policy: Simple Rules
An alternative approach that I find helpful in evaluating the
stance of policy is to consult prescriptions from simple policy rules.
Research suggests that these rules perform well in a variety of models
and tend to be more robust than the optimal control policy derived from
any single macroeconomic model.12 Of course, a wide variety of simple
rules have been proposed in the academic literature, and their policy
implications can differ significantly depending on the particular
specification. Moreover, given our statutory mandate of maximum
employment and price stability, it seems reasonable to focus on rules
that mirror these two objectives by prescribing how the federal funds
rate should be adjusted in response to two gaps: the deviation of
inflation from its longer-run goal and the deviation of unemployment
from my estimate of its longer-run normal rate. In my view, rules
specified along these lines can serve as useful benchmarks for gauging
the stance of policy and for communicating with the public about the
rationale for our policy decisions.
Indeed, in the statement on longer-run goals and policy strategy
that the FOMC issued in January, we underscored our commitment to
following a balanced approach in promoting our dual objectives. The
commitment to a balanced approach has crucial implications when it comes
to choosing sensible benchmarks from among the many alternative policy
rules. In particular, any benchmark rule should conform to the so-
called Taylor principle, which states that, other things being equal, a
central bank should respond to a persistent increase in inflation by
raising nominal short-term interest rates by more than the increase in
inflation so that the real rate of interest rises, thereby helping to
bring inflation back down. Moreover, I think it is essential that policy
rules incorporate a sufficiently strong response to resource slack,
typically either the output gap or the unemployment gap, to help bring
the economy back toward full employment expeditiously. John Taylor has
proposed two simple and well-known policy rules along these lines. The
rule that Taylor proposed in 1993 incorporates a fairly modest response
to economic slack. Later, in a 1999 study, he considered a variant of
that rule that was twice as responsive to slack.13 Taylor himself
continues to prefer his original rule, which I will refer to as the
Taylor (1993) rule. In my view, however, the later variant–which I will
refer to as the Taylor (1999) rule–is more consistent with following a
balanced approach to promoting our dual mandate. Importantly, because of
the stabilizing effects of the Taylor principle, both the Taylor (1993)
and Taylor (1999) rules imply that inflation returns over time to the
longer-run goal of 2 percent.14
-more- (4 of 7)
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