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Wednesday, November 21, 2012

A Simple Rule for Monetary Policy After 20 Years

It was 20 years ago today at a conference in Pittsburgh that I first presented what is now called the Taylor rule. Here’s the November 1992 Stanford working paper. It’s nearly impossible to predict which ideas will be picked up by policy makers and which won’t, and I certainly didn’t predict in 1992 that the Fed and other central bankers would still be referring to the idea in 2012.

Last week, for example, the Taylor rule served as a reference point for two very different talks by two members of the FOMC. In a speech in Berkeley, Vice Chair Janet Yellen talked about forward guidance. She argued that the federal funds rate should stay below the Taylor rule for a while longer and even below a “Modified Taylor rule” with a higher response to the output gap. She said that “times are by no means normal now, and the simple rules that perform well under ordinary circumstances just won’t perform well with persistently strong headwinds restraining recovery and with the federal funds rate constrained by the zero bound.” So that means more discretion, and, in my view, more drag on the economy.

Philadelphia Fed President Charles Plosser also spoke about forward guidance last week, but he saw no reason not to use a policy rule under current circumstances, and he recommended setting interest rates according to one of those policy rules. That would bring a more rules-based policy, which experience over the past 30 years shows would be better for the economy, as I argued in a talk at the same conference where Charlie spoke.

New research by Kansas City Fed economist George Kahn provides highly relevant econometric evidence on the issue. In an article forthcoming in the Kansas City Fed’s Economic Review, he estimates simple policy rules over relatively well-performing periods. He finds that the estimated parameters over these periods are very close to those of the rule I proposed 20 years ago, though with a different constant term implying a higher equilibrium federal funds rate.