NEW YORK (MNI) – The following is the fifth of seven sections of
Federal Reserve Vice Chair Janet Yellen’s text and footnotes prepared
Wednesday for the Money Marketeers of New York University:

Figure 8 shows the projected paths for the federal funds rate
called for by these two policy rules, along with the optimal control
path that I presented earlier.15 These projections are constructed using
the FRB/US model, conditioned on the same illustrative baseline outlook
that I used a moment ago. The Taylor (1993) rule calls for the federal
funds rate to begin rising in early 2013, whereas the Taylor (1999) rule
has its liftoff in early 2015, a lot closer to the optimal control path.
A sizable literature has examined the performance of simple rules like
these by conducting stochastic simulations with a range of economic
models. Many studies, including Taylors own analysis, suggest that the
Taylor (1999) rule generates considerably less variability in real
activity and only slightly more variability in inflation than his
original rule.16 Given the differential responses to economic slack
across these two rules, this finding is hardly surprising, but it is a
key reason why I consider the Taylor (1999) rule to be a more suitable
guide for Fed policy.

While the Taylor (1999) rule can serve as a useful policy
benchmark, its prescriptions fail to take into account some
considerations that I consider important in the current context. In
particular, this rule does not fully take into account the implications
of the zero lower bound on nominal interest rates and hence tends to
understate the rationale for maintaining a highly accommodative stance
of monetary policy under present circumstances.

Importantly, resource utilization rates have been so low since late
2008 that a variety of simple rules have been calling for a federal
funds rate substantially below zero, which of course is not possible.
Consequently, the actual setting of the target funds rate has been
persistently tighter than such rules would have recommended. The FOMCs
unconventional policy actions–including our large-scale asset purchase
programs–have surely helped fill this policy gap but, in my judgment,
have not entirely compensated for the zero-bound constraint on
conventional policy. In effect, there has been a significant shortfall
in the overall amount of monetary policy stimulus since early 2009
relative to the prescriptions of the simple rules that Ive described.
Analysis by some of my Federal Reserve colleagues suggests that monetary
policy can produce better economic outcomes if it commits to making up
for at least some portion of the cumulative shortfall created by the
zero lower bound–namely, by maintaining a highly accommodative monetary
policy for longer than a simple rule would otherwise prescribe.17 This
consideration is one important reason that the optimal control
simulation generates a more accommodative path than the Taylor (1999)
rule. Risk-management considerations strengthen the case for maintaining
a highly accommodative policy stance longer than might otherwise be
considered appropriate.

In particular, the FOMC has considerable latitude to withdraw
policy accommodation if the economic recovery were to proceed much
faster than expected or if inflation were to come in higher. In
contrast, if the recovery faltered or inflation drifted down, the
Committee could provide additional stimulus using its unconventional
tools, but doing so involves costs and risks. Given the unprecedented
nature of the current economic situation and the limits placed on
conventional policy by the zero lower bound on interest rates, these
issues of risk management take on special importance. More broadly,
these considerations help illustrate why it would be imprudent to adhere
mechanistically to the prescriptions of any single policy rule. Such
rules can serve as useful benchmarks for facilitating monetary policy
deliberations and communications, but a dose of good judgment will
always be essential as well.

Uncertainty and Policy Conditionality

The policy prescriptions Ive discussed thus far are conditioned on
an illustrative baseline forecast for unemployment and inflation.
Because any economic forecast is inherently uncertain, the FOMC’s
forward policy guidance states explicitly that the Committee “currently
anticipates” that economic conditions are likely to warrant such a
stance of policy. The guidance does not state that the Committee will
keep the funds rate exceptionally low until at least late 2014. Id
consider it completely appropriate to modify the specification of the
forward guidance in response to significant changes in the economic
outlook.

Potential modifications of the forward guidance can be illustrated
by showing how the Taylor (1999) rule responds to two different shifts
in the outlook. Figure 9 shows one scenario in which the recovery turns
out to be unexpectedly strong, with the unemployment rate reaching 6
percent by the end of 2014 and inflation moving a little above 2 percent
later in the decade. It also shows a second scenario in which the
recovery is unexpectedly weak, with the unemployment rate remaining
above 8 percent until early 2014. In this scenario, inflation stays
persistently below 2 percent. In the stronger scenario, the Taylor
(1999) rule calls for the liftoff from the zero lower bound to move
forward to the beginning of 2014. In that event, of course, the FOMC
would not only raise the federal funds rate sooner than our current
guidance suggests but would also begin to remove other forms of
accommodation and draw down the balance sheet sooner than in the
baseline.

-more- (5 of 7)

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