By Steven K. Beckner

(MNI) – Federal Reserve Board Vice Chair Janet Yellen said Tuesday monetary
policy rules such as the Taylor Rule, which prescribes changes in the funds rate
when inflation and/or unemployment deviate from the norm, don’t work well in
circumstances such as these, when the economy is recovering from a financial
crisis and the funds rate is at the zero lower bound.

She said the Modified Taylor Rule “would raise the federal funds rate
substantially earlier than the optimal path and thereby leads to more protracted
deviations of the unemployment rate above its longer-run normal level without
any measurable gains in keeping inflation closer to the 2% target.”

“In contrast, the optimal policy results in better economic outcomes,” she
said. “In effect, it compensates for the period of economic weakness induced by
both the zero lower bound and the unusual persistence and severity of the
headwinds now buffeting the economy by holding the federal funds rate lower for
longer than the modified Taylor rule, thereby maintaining greater accommodation
as the economic recovery takes hold.”

Yellen said her simulations of the “optimal” monetary policy suggest that
“once liftoff from the zero lower bound occurs, it would be optimal for the
federal funds rate to remain for some time below the prescriptions from a rule,
such as the modified Taylor rule, that might in the past have provided a good
guide to the Committee’s action.”

She said this “optimal” policy is “consistent” with what the FOMC said on
Sept. 13 and again on Oct. 24 about continuing to buy $40 billion per month in
mortgage-backed securities until there is “substantial” labor market improvement
and keeping policy “highly accommodative … for a considerable time after the
economic recovery strengthens.”

Yellen, who chairs an FOMC subcommittee on communications policy, said she
and her colleagues are continuing to work toward ways to better convey their
rate intentions to the public and the markets.

She said she expects the FOMC’s long run-goals and strategy statement, with
its “balanced approach,” to be “reaffirmed” in January 2013 and in subsequent

Beyond that, she said it is desirable to further enhance Fed
communications, particularly regarding its “forward guidance” on the path of the
funds rate.

“One logical possibility” would be for the FOMC to “provide the public with
its projections for inflation and the unemployment rate together with what it
views as appropriate paths both for the federal funds rate and its asset
holdings, conditional on its current outlook for the economy.”

“Over time, these projections would be revised in response to incoming data
that alters the Committee’s economic outlook or, instead, because the Committee
decides to alter its policy stance,” she said.

An alternative which she said is “under active consideration” would be for
the FOMC to “build on the individual projections of macroeconomic variables and
policy already included in its quarterly SEP (Summary of Economic Projections)
to provide at least some further information about how these individual
projections inform the Committee’s collective policy judgment.”

Yellen said “another alternative that deserves serious consideration would
be for the Committee to provide an explanation of how the calendar date guidance
included in the statement–currently mid-2015–relates to the outlook for the
economy, which can and surely will change over time.”

“Going further, the Committee might eliminate the calendar date entirely
and replace it with guidance on the economic conditions that would need to
prevail before liftoff of the federal funds rate might be judged appropriate,”
she said, noting that Chicago Federal Reserve Bank President Charles Evans and
others have offered varying unemployment and inflation thresholds at which the
funds rate would need to be raised.

Yellen described herself as “strongly supportive” of such ideas, because
“it would enable the public to immediately adjust its expectations concerning
the timing of liftoff in response to new information affecting the economic

“This market response would serve as a kind of automatic stabilizer for the
economy,” she said. “Information suggesting a weaker outlook would automatically
induce market participants to push out the anticipated date of tightening and
vice versa.”

What’s more, Yellen said “the use of inflation and unemployment thresholds
would help the public understand whether a shift in the calendar date, assuming
that one is still included in the statement, reflects a change in the
Committee’s economic outlook or, alternatively, a change in its view concerning
the appropriate degree of accommodation.”

“Since monetary policy works in large part through the public’s perceptions
of the FOMC’s systematic behavior, this distinction is critical,” she added.

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** MNI **


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