Donald L Kohn: John Taylor rules
Speech by Mr Donald L Kohn, Vice Chairman of the Board of Governors of the US Federal
Reserve System, at the Conference on John Taylor's Contributions to Monetary Theory and
Policy, Federal Reserve Bank of Dallas, Dallas, Texas, 12 October 2007.
The original speech, which contains various links to the documents mentioned, can be found on the US Federal
Reserve System's website.
* * *
The role of simple rules in monetary policymaking
It is a pleasure and an honor to speak at this conference honoring John Taylor and his
contributions to monetary theory and policy. As you have already heard from Chairman
Bernanke and the other speakers today, John has made a number of seminal contributions
to the field of macroeconomics. What has distinguished John's work, in my view, is that he
takes policymaking in the real world seriously.1
Taking policymaking seriously involves understanding the constraints imposed on our
decisions by partial information and incomplete knowledge of economic relationships. It also
implies the use of empirically valid models that acknowledge the efforts of households and
businesses to anticipate the future and maximize their welfare over time. In the late 1980s
and early 1990s, macroeconomics was focused mainly on real business cycles and
endogenous growth theory. During this period, John was one of a very small number of
academic economists who continued to pursue research aimed at informing the conduct of
monetary policy. John's Carnegie Rochester conference paper published in 1993 is an
excellent example of this research.
Importantly, John's legacy to the Federal Reserve has not been confined to enhancing our
understanding of monetary policy. In addition, he has turned out legions of students who
have followed in his footsteps in their interest in policy. Many of them have spent time in the
Federal Reserve, producing a rich array of contributions to policymaking and research.
John and I have spent countless hours discussing how the Federal Reserve arrives at
decisions about monetary policy and how it should arrive at decisions. Those conversations
began in earnest in the late 1980s, when John was on the Council of Economic Advisers,
and they have continued to the present day. They have occurred not only in offices and
classrooms in Washington and Stanford and at numerous conferences around the globe, but
also around dinner tables in Washington and Palo Alto and on hiking trails from Vermont to
Wyoming. Those conversations made me a better policy adviser and then policymaker, and
they have had the added and very special bonus of allowing Gail and me to count John and
Allyn among our friends. I can't think of a better way to honor John's contributions than to
continue that discussion around the dinner tables of Dallas by reflecting on the role of simple
rules in informing policymaking.
Three benefits of simple rules in monetary policymaking
In his Carnegie Rochester conference paper, John considered a simple policy rule under
which the nominal federal funds rate is adjusted in response to both the gap between real
and trend gross domestic product (GDP) and the gap between the inflation rate and
policymakers' target. Based on data for the previous few years, John calibrated the long-run
target for inflation and the two parameters that determine the responsiveness of the federal
funds rate to the two gaps. The equilibrium real interest rate was based on a longer history of
actual real interest rates. In the handout, Figure 1A depicts the actual nominal funds rate and
the Taylor rule prescriptions between 1987 and 1992, as presented in John's paper. Despite
its simplicity, this policy rule fits the data remarkably well; it described a period of generally
successful policymaking; and it adhered to the Taylor principle of adjusting the nominal rate
more than one-for-one with changes in the inflation rate, so it provided a plausible template
for future success. It is no wonder that John has been such a dedicated salesman and that
his efforts have been so well received in academia and policy councils.
Following John's seminal contribution, many other economists have engaged in research on
similar policy rules and, together with John, have identified several benefits of such rules in
conducting monetary policy. I will elaborate on three of them.
The first benefit of looking at a simple rule like John's is that it can provide a useful
benchmark for policymakers. It relates policy setting systematically to the state of the
economy in a way that, over time, will produce reasonably good outcomes on average.
Importantly, the emphasis is on levels and gaps, not growth rates, as inputs to the policy
process. This emphasis can be a problem when a level, say of potential GDP, is in question,
but in many respects it is also a virtue. For the United States, the two gaps relate directly to
the legislative mandate of the Federal Reserve to achieve stable prices and maximum
employment. Moreover, those two gaps fit directly into most modern macroeconomic
theories, which tell us something about their relationship and how that relationship can be
affected by the type of shock hitting the economy.
Model uncertainties make the simplicity of the rule particularly important for the policymaker
because research suggests that the prescriptions from simple rules can be more robust than
optimal-control policies. Optimal-control policies can depend critically on the exact
specification of the model, and clearly there is no consensus about which model best
describes the U.S. economy.
Federal Reserve policymakers are shown several versions of Taylor rules in the material we
receive before each meeting of the Federal Open Market Committee (FOMC). I always look
at those charts and tables and ask myself whether I am comfortable with any significant
deviation of my policy prescription from those of the rules.
A second benefit of simple rules is that they help financial market participants form a
baseline for expectations regarding the future course of monetary policy. Even if the actual
policy process is far more sophisticated than any simple rule could completely describe, the
rule often provides a reasonably good approximation of what policymakers decide and a
framework for thinking about policy actions. Indeed, many financial market participants have
used the Taylor rule to understand U.S. monetary policy over the past fifteen years. Investors
and other market participants are going to form expectations about policy and act on those
expectations. The more accurate and informed those expectations are, the more likely are
their actions to reinforce the intended effects of policy.
A third benefit is that simple rules can be helpful in the central bank's communication with the
general public. Such an understanding is important for the transmission mechanism of
monetary policy. Giving the public some sense of how the central bank sees the output and
inflation gaps and how they are expected to evolve will help it understand the central bank's
objectives and how policymakers are likely to respond to surprises in incoming data.
Four limitations of simple rules
Simple rules have limitations, of course, as benchmarks for monetary policy. To quote from
John's Carnegie Rochester paper, "a policy rule can be implemented and operated more
informally by policymakers who recognize the general instrument responses that underlie the
policy rule, but who also recognize that operating the rule requires judgment and cannot be
done by computer" (p. 198). In that context, four limitations of simple rules are important.
The first limitation is that the use of a Taylor rule requires that a single measure of inflation
be used to obtain the rule prescriptions. The price index used by John in the Carnegie
Rochester paper was the GDP price deflator. Other researchers have used the inflation
measure based on the consumer price index (CPI). Over the past fifteen years, the Federal
Reserve has emphasized the inflation rate as measured by changes in the price index for
personal consumption expenditures (PCE). Many researchers have also explored the use of
core price indexes, which exclude the volatile food and energy components, as better
predictors of future inflation or as more robust indicators of the sticky prices that some
theories say should be the targets of policy. To be sure, over long periods, most of these
measures behave very similarly. But policy is made in the here and now, and the various
indexes can diverge significantly for long stretches, potentially providing different signals for
the appropriate course of monetary policy.
Second, the implementation of the Taylor rule and other related rules requires determining
the level of the equilibrium real interest rate and the level of potential output; neither of them
are observable variables, and both must be inferred from other information. John used
2 percent as a rough guess as to the real federal funds rate that would be consistent with the
economy producing at its potential. But the equilibrium level of the real federal funds rate
probably varies over time because it depends on factors such as the growth rate of potential
output, fiscal policy, and the willingness of savers to supply credit to households and
businesses. Inaccurate estimates of this rate will mislead policymakers about the policy
stance required to achieve full employment. In a similar vein, real-time estimates of potential
output can be derived in a number of ways and - as shown by Orphanides (2003) and others
- they are subject to large and persistent errors. If policymakers inadvertently rely on flawed
estimates, they will encounter persistent problems in achieving their inflation objective.
The third limitation of using simple rules for monetary policymaking stems from the fact that,
by their nature, simple rules involve only a small number of variables. However, the state of a
complex economy like that of the United States cannot be fully captured by any small set of
summary statistics. Moreover, policy is best made looking forward, that is, on the basis of
projections of how inflation and economic activity may evolve. Lagged or current values of
the small set of variables used in a given simple rule may not provide a sufficient guide to
future economic developments, especially in periods of rapid or unusual change. For these
reasons, central banks monitor a wide range of indicators in conducting monetary policy. In
his Carnegie Rochester paper, John mentioned the stock market crash of October 1987 as
an example of how other variables can and should influence the course of monetary policy in
some situations.
The final limitation I want to highlight is that simple policy rules may not capture
riskmanagement considerations. In some circumstances, the risks to the outlook or the
perceived costs of missing an objective on a particular side may be sufficiently skewed that
policymakers will choose to respond by adjusting policy in a way that would not be justified
solely by the current state of the economy or the modal outlook for output and inflation gaps.
Policy rules around 2003
Some of the ambiguities and potential pitfalls in the use of simple policy rules are highlighted
by considering their prescriptions for a period earlier in this decade. Turning to Figure 1B, the
solid line indicates the actual federal funds rate between the first quarter of 1993 and the
second quarter of 2007, and the dashed line shows the prescriptions of the Taylor rule using
the same methodology that John used in his Jackson Hole remarks this year.2 For the earlier
part of the sample, the prescription from this simple rule tracks the actual funds rate relatively
well. As John pointed out, a notable deviation happened beginning in 2002, and I would like
to discuss that period to illustrate the limitations I noted earlier.
Inflation measure
The first limitation is related to the measure used for the inflation variable included in the
rules. The rule prescriptions depicted by the dashed line in Figure 1B are based on the
headline CPI. But as you know, the FOMC often looks at core inflation, stripping out the
effects of energy and food prices, as a better indicator of future price behavior. The dotted
line represents the rule prescriptions based on the chain-weighted core CPI, which the
Bureau of Labor Statistics has produced since 2000. Using this measure lowers the
prescribed funds rate by about 2 percentage points during 2003, bringing the rule
prescriptions much closer to the actual path of policy. The reason for the improvement is
evident from Figure 2A, on the other side of the handout: Even though the headline and core
CPI measures were broadly similar in the mid- to late 1990s, these measures diverged
substantially between 2003 and 2005.
Potential output
The second limitation relates to the challenge of judging the level of potential output in real
time. To illustrate this point, Figure 2B plots three measures of the output gap. The solid line
is the real-time estimate by the Congressional Budget Office (CBO) that was used in the
Taylor rule prescriptions in Figure 1B, while the dashed line depicts the CBO's ex post
estimate of the output gap as of the third quarter of 2007. Back in 2003, the CBO estimated
that output at that time was below potential by only 1 percent. With the benefit of four more
years of data, the CBO currently estimates that the output gap for the first half of 2003 was
considerably wider - about 3 percent. In addition, the dotted line represents an alternative
measure of resource utilization derived from the unemployment rate and an estimate of the
natural rate of unemployment (NAIRU) taken from the Board staff's FRB/US model. In fact,
the unemployment rate was rising through the middle of 2003, so the FOMC had every
reason to believe that the output gap was widening at that time. Using this
unemploymentbased measure rather than the real-time CBO measure would reduce the prescriptions of
simple policy rules by roughly 1/2 percentage point in early 2003.
Other variables
The third limitation in my list was that the small set of economic measures included in simple
rules may not fully reflect the state of the economy. Around 2003, financial market conditions
may not have been adequately summarized by the assumed 2 percent equilibrium federal
funds rate. Accounting scandals caused economic agents to lose confidence in published
financial statements and in bond ratings. The result was higher uncertainty about the
financial health of firms, and credit spreads widened substantially. Figure 2C shows that risk
spreads on corporate bonds were elevated in this period. Other things equal, such spreads
would reduce the federal funds rate needed to achieve full employment, perhaps explaining a
portion of the gap between the actual federal funds rate and the outcome from the policy rule
during this period.
Risk management
The last item on my list of limitations was that simple rules do not take account of
riskmanagement considerations. As shown in Figure 2A, the core CPI inflation rate for 2003 was
falling toward 1 percent. The real-time reading of the core PCE inflation rate (not shown) was
on average even lower than the comparable CPI figure. Given these rates, the possibility of
deflation could not be ruled out. We had carefully analyzed the Japanese experience of the
early 1990s; our conclusion was that aggressively moving against the risk of deflation would
pay dividends by reducing the odds on needing to deal with the zero bound on nominal
interest rates should the economy be hit with another negative shock. This factor is not
captured by simple policy rules.
A final note
I have offered this analysis in the spirit of so many of the discussions I have had with John.
His framework has been enormously important to policymaking in the Federal Reserve, and
it has yielded many benefits. Nevertheless, it's important to keep in mind that some
significant practical limitations also are associated with the application of such rules in real
time. In other words, it's not so simple to use simple rules!
References
Orphanides, Athanasios (2003). "The Quest for Prosperity without Inflation," Journal of
Monetary Economics, vol. 50 (April), pp. 633-63.
Poole, William (2007). "Understanding the Fed," Federal Reserve Bank of St. Louis, Review,
vol. 89 (January/February), pp. 3-14.
Taylor, John B. (1993). "Discretion versus Policy Rules in Practice," Carnegie-Rochester
Conference Series on Public Policy, vol. 39, pp. 195-214.
_________ (2007). "Housing and Monetary Policy," speech delivered at "Housing, Housing
Finance, and Monetary Policy," a symposium sponsored by the Federal Reserve Bank of
Kansas City, held in Jackson Hole, Wyo., August 30-September 1.