William C Dudley: Panel remarks at the Brookings Institution
Remarks by Mr William C Dudley, President and Chief Executive Officer of the Federal
Reserve Bank of New York, at "The Fed at a crossroads: Where to go next?", Brookings
Institution, Washington DC, 15 October 2015.
* * *
It is a great pleasure to be here today to participate in this panel with John Taylor. I am going
to take today's topic - "Where to go next?" - to address the issue of how monetary policy
should be conducted. This is an issue that is getting considerable attention among
policymakers here in Washington, D.C. To put succinctly the question I wish to tackle: Is it
better for policymakers to start with a formal rule as the default position, or for policymakers
to have a more flexible approach that considers a broader set of factors in setting the
monetary policy stance? As always, what I have to say today reflects my own views and not
necessarily those of the Federal Open Market Committee (FOMC) or the Federal Reserve
System.1
To get right to the punch line, I favor a more flexible approach that incorporates a broader set
of factors into the monetary policy decision-making process. The world is complex and
everchanging. There are many factors that can affect the economic outlook and the attainment of
the Federal Reserve's mandated objectives and, thereby, the appropriate stance of monetary
policy.
At the same time, I do not favor total discretion in which the monetary policy strategy is
determined in an ad hoc fashion as we go along. For monetary policy to be most effective,
market participants, households and businesses need to be able to anticipate how the
Federal Reserve is likely to respond to evolving conditions. That is because the transmission
of monetary policy to the real economy depends not only on what policymakers decide to do
today, but also on what the public anticipates that the FOMC is likely to do in the future as
the economic outlook changes and evolves.
Our experience at the zero lower bound in recent years underscores how important
expectations are in influencing the effectiveness of monetary policy. Policymakers thus need
to act in a systematic and consistent manner so that expectations are formed accurately and
economic behavior can respond consistently with those expectations. In my view, this
consideration rules out a totally discretionary monetary policy.
Before I critique the use of prescriptive rules in monetary policy-making, I'd like to make it
clear at the start that the Taylor Rule (by which I mean the formulation based on John's 1993
and 1999 papers) has a number of positive attributes that make it a useful reference for
policymakers. First, it has two parameters - the long-term inflation objective and the level of
potential output - that map directly to the Federal Reserve's dual mandate objectives.
Second, the Rule has the desirable feature that when economic shocks push the economy
away from the central bank's objectives, the Taylor Rule prescribes a policy response that
can help push the economy back toward the central bank's goals. Third, a number of studies
have shown that Taylor Rules are robust in the sense that they generally perform quite well
across a range of different assumptions about how the economy is structured and operates.
Despite these attractive features, I don't believe that any prescriptive rule, including the
Taylor Rule, can take the place of a monetary policy framework that incorporates the
FOMC's collective assessment of the large number of factors that impact the economic
outlook.
As I see it, the Taylor Rule has several significant shortcomings that can be detrimental to
the attainment of the Federal Reserve's mandated objectives. These shortcomings are not
just theoretical; they have been very relevant to monetary policy in recent years. First, the
Taylor Rule is not forward-looking. Its policy prescription is based on the current size of the
output gap and the deviation of current inflation from the Fed's objective, not on how these
variables are likely to evolve in the future. So, in a rapidly changing environment, the Taylor
Rule and other similar prescriptive rules will wind up being "behind the curve." For example,
in the fall of 2008, Taylor Rule prescriptions were well above the level of rates that was
appropriate given the sharp and persistent deterioration in the economic outlook and the
sharp tightening in financial conditions that occurred during that period.
Of course, many economists at that time recognized that such prescriptions would have been
inappropriate and suggested various ad hoc modifications to the prescriptions - in fact, John
himself suggested that modifications to his rule were appropriate at that time.2
Nonetheless, there was no consensus about the "right" modification to the rules at that time,
in part, because the circumstances were unprecedented and the outlook so uncertain. If the
FOMC had been required to justify to Congress deviations from a reference rule at that time,
I believe that this would have slowed down how we responded to the crisis and would have
resulted in a monetary policy that was not sufficiently accommodative. The consequence
could have been a longer financial crisis and a deeper recession.
Second, the Taylor Rule, as typically used, assumes that a 2 percent real short-term interest
rate is consistent with a neutral monetary policy. However, a large literature concludes that
the equilibrium real short-term rate is very unlikely to be constant, with its value affected by
many factors, including the pace of technological change, fiscal policy and the evolution of
financial conditions.3
Sometimes it can be much higher than 2 percent. Presumably, this was the case during the
late 1990s as rapid technological change lifted productivity growth. Sometimes it can be well
below 2 percent. For example, when credit availability dried up during the financial crisis in
late 2008, this drove down the equilibrium real rate far below 2 percent.
More recently, the slow growth rate of the economy and the low rate of inflation are evidence
that the equilibrium real short-term rate today is well below the 2 percent rate assumed in the
Taylor Rule. If 2 percent really was consistent with a neutral monetary policy, then the very
low real rates of recent years - buttressed by our large-scale asset purchases - should have
been extraordinarily accommodative. As a result, we should have grown much faster than
the 21⁄2 percent pace evident over the past couple of years and seen an inflation rate much
higher than what we experienced. This conclusion is supported by a number of more formal
models. For example, the Laubach-Williams model currently estimates that the equilibrium
real short-term rate is around zero percent.4
Third, the Taylor Rule - and more broadly, any prescriptive rule for the systematic
quantitative adjustment of the policy rate to changes in intermediate policy inputs such as
real GDP or inflation - is incomplete because it does not fully account for factors that are
crucial to how monetary policy impulses are transmitted to the real economy. Monetary policy
affects economic activity through its impact on financial conditions - including the level of
equity prices, bond yields, the foreign exchange value of the dollar and credit conditions. If
the relationship between the federal funds rate and other indicators of financial conditions
were stable, then one could just focus on the level of short-term rates.5
But, because financial conditions vary considerably relative to short-term rates, as we have
seen in the financial crisis and its aftermath, one needs to consider developments in financial
conditions more broadly in setting monetary policy.
In fact, at times, when short-term rates have been pinned at the zero lower bound, the
Federal Reserve has taken actions that eased financial conditions without changing
shortterm interest rates. Such actions have included forward guidance that the FOMC was likely
to keep short-term rates low for a long time and large-scale asset purchases that led to lower
bond term premia.
Now, as I said at the start, just because I don't want to follow a rule mechanically does not
mean that I favor the polar opposite - that is, a fully discretionary monetary policy in which
market participants, households and businesses cannot anticipate how monetary policy is
likely to evolve as economic and financial market conditions and the economic outlook
change. If households and businesses do not have a good notion of how the Federal
Reserve will respond to changing economic and financial market conditions, then this would
loosen the linkage between short-term rates and financial conditions. This would also likely
lead to greater uncertainty about the outlook and higher risk premia, and it would make it
more difficult for policymakers to attain their objectives.
Instead, what I favor is a careful elucidation of those factors that influence the economic
outlook and how monetary policy is likely to respond to changes in the outlook. This includes
fiscal policy, productivity growth, the international outlook and financial conditions, as well as
how much employment and inflation deviate from the Fed's objectives. By conducting policy
in a transparent way and communicating what is important in determining the central bank's
reaction function, I think policymakers can strike the best balance between a monetary policy
that fully incorporates the complexity of the world as it is, while, at the same time, retaining
considerable clarity about how the FOMC is likely to respond to changing circumstances. A
formal policy rule such as the Taylor Rule misses this balance by going too far in one
direction.
What is important for attaining the Federal Reserve's mandated objectives is not that
monetary policy is described in terms of a formal prescriptive rule, but rather that the FOMC's
intentions and strategy are well understood by the public. This argues for clear
communication through the FOMC meeting statements and minutes, the FOMC's statement
concerning its longer-term goals and monetary policy strategy, the Chair's FOMC press
conferences and testimonies before Congress, and speeches by the Chair and other FOMC
participants. But it also is important that the strategy be the "right" reaction function. This
means a policy approach that responds appropriately to important factors beyond the two
parameters of the Taylor Rule - the output gap estimate and the rate of inflation.
Thank you for your kind attention.