For release on delivery
1:30 p.m. EDT
October 10, 2023
Monetary Policy Analysis and the Development of Federal Reserve Policymaking
Remarks by
Christopher J. Waller
Member
Board of Governors of the Federal Reserve System
at
"The Legacy of Bennett McCallum and Lessons for Monetary Policy Today," a conference
sponsored by
the Mercatus Center at George Mason University
Washington, D.C.
October 10, 2023
It is a pleasure to be here to honor the legacy of Bennett McCallum by discussing
his work on monetary policy. Over the years, I was fortunate to cross paths with Ben
several times-from when I was a young academic economist to when I was research
director at the Federal Reserve Bank of St. Louis. But, like many of you, most of my
exposure to Ben McCallum's thinking has consisted of reading, and learning from, his
writings on monetary policy.
Ben was an influential researcher who focused on a number of topics that are key
to monetary policy, some of them highlighted in today's panel sessions, including policy
rules, instruments, and targets. When I was an academic, these were research interests
that I shared with Ben. More recently, since I became a member of the Federal Open
Market Committee (FOMC), the same issues have been at the forefront of my work, as I
will explain in my remarks today.
I will cover these issues in the context of discussing broad developments in U.S.
monetary policy over the past quarter-century.1 In doing so, I'm motivated by
McCallum's 1999 paper "Recent Developments in Monetary Policy Analysis: The Roles
of Theory and Evidence," which was a review of the previous 25 years.2 In my remarks,
I'll first talk about changes that have taken place since the 1990s in the way in which the
FOMC has conducted policy. Then I'll turn to a discussion of monetary policy rules,
how Ben thought about them, their use as an input into policymakers' decisions, and the
choice of instruments and targets in policy rules.
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Developments in Monetary Policy from 1998 to 2023
McCallum's review, which was largely written in 1998, contrasted monetary
policy analysis in 1973 and 1998. In 1973, many economies were adjusting to the demise
of the Bretton Woods international monetary system, and their domestic monetary policy
regimes were starting to develop alongside floating exchange rates as well as the first oil
shock that materialized during that year. In the U.S., continued dissatisfaction with
economic performance-particularly high inflation-led to the restrictive monetary
policy implemented by Paul Volcker from 1979 to 1982. The disinflation delivered by
this policy was followed by greatly improved overall economic performance in the period
that came to be known as the Great Moderation. The Great Moderation was also
associated, in the era of Alan Greenspan's leadership of the Federal Reserve, with
inflation moving down further, to rates consistent with price stability.
Consequently, by the time of McCallum's 1998 retrospective, U.S. monetary
policy had established a track record that was held in very high regard. It was widely
believed that the Fed had lost credibility in the 1970s in terms of its willingness to fight
inflation. Chairman Volcker's actions restored the Fed's credibility. Following the
Volcker disinflation, economic research focused on the idea that monetary policy
strategies would be fully effective only if they were credible. This idea led to an
intensified debate about "rules versus discretion." The issue was how to maintain the
basis for U.S. monetary policy that Volcker had created. As I'll discuss further, what was
needed was a way to maintain the credibility of the institution, as opposed to relying on
the credibility of an individual Fed Chair. One approach was for the FOMC to commit to
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following a policy rule and explicit policy targets, combined with communication of its
policy rule to the public. And this approach was a key aspect of Ben McCallum's work.
In the 25 years since 1998, there have been numerous changes in U.S. monetary
policy arrangements. These have included several important reforms that were
substantially along the lines advocated by Ben and others. In multiple ways, the FOMC's
policy framework has become much more explicit. At the end of 2007, the FOMC began
publishing a quarterly Summary of Economic Projections, collecting information on
individual meeting participants' forecasts. Then, in January 2012, the FOMC issued a
Statement on Longer-Run Goals and Monetary Policy Strategy-also known as our
consensus statement. The consensus statement has been reaffirmed every year and
revised several times. From its inception, it made the price-stability goal that is part of
our congressional mandate more concrete by indicating that Federal Reserve
policymakers interpret it as a 2 percent longer-run inflation rate (in the personal
consumption expenditures price index). In 2011, Ben Bernanke initiated the practice of
postmeeting press conferences, which under Chair Powell's leadership now follow every
FOMC meeting.
In the summer of 2020, FOMC participants released a revised consensus
statement that further elaborated their interpretation of the dual-mandate goals of
maximum employment and price stability and how the Committee would pursue those
objectives. The new statement explicitly recognized the policy tools of asset purchases
and forward guidance on the federal funds rate. These tools were developed during the
period, which started in late 2008, in which the federal funds rate was at the effective
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lower bound (ELB), and they were used again during the new ELB episode that began in
March 2020.
As many observers have noted over the years, the introduction of the 2 percent
inflation objective and other formalizations of the Federal Reserve's monetary policy
framework actually took place well after disinflation had been achieved under Volcker
and consolidated under Greenspan. It might be asked why-with price stability secured
by around the mid-1990s-these formalizations were thought necessary. The answer lies
in the fact that a well-understood monetary policy regime is needed to make price
stability and anchored inflation expectations durable features of the economic
environment.3 Communicating key characteristics of the regime-including the
numerical inflation target and policymakers' reaction function-makes it concrete and
transparent in the eyes of the general public while also enhancing the central bank's
credibility and the effectiveness of monetary policy.
In this connection, the design of modern central bank policy regimes has drawn
importantly on the literature on monetary policy rules. It is no coincidence that the
period in the 1990s and 2000s of major strides in central bank transparency, frameworks,
and communications took place alongside a resurgence of interest in research on
monetary policy rules. The literature on monetary policy rules and on inflation targeting
provided insights about how the U.S. monetary policy framework could achieve our dual-
mandate goals of maximum employment and stable prices. And we have made use of
those insights. By setting out a long-run inflation goal, while indicating that we take
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maximum employment as a long-term variable largely determined by nonmonetary
factors, we make clear that we do not view our mandate as licensing us to seek
unsustainably high levels of real output through bouts of loose monetary policy. As the
literature on time consistency shows, not only would such monetary policy looseness
sacrifice the achievement of long-run price stability, it would also not even deliver higher
output in the long run.4 Ben McCallum once summarized the consensus as follows:
"The pragmatic argument for inflation targeting begins with the proposition that, from a
long-run (i.e., steady state) perspective, monetary policy has a dominating influence on
an economy's (average) inflation rate and a negligible influence on its rate of
unemployment or output relative to capacity. This proposition has wide support among
central bankers and also within the academic community."5
The benefits of an explicit, transparent policy regime are brought out clearly by
our recent experience. When the FOMC began raising the federal funds rate in March
2022 to tame inflation, it used forward guidance to make clear our intention to reach a
policy stance that is sufficiently restrictive to bring inflation back to 2 percent. I believe
that this guidance has made our policy actions more effective.
The FOMC's Reaction Function and the Analysis of Monetary Policy Rules
Forward guidance and the postmeeting statement are major means by which the
FOMC is able to communicate to households, businesses, and financial markets key
aspects of our reaction function. The reaction function connects decisions on our main
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policy instrument-the federal funds rate-to inflation and other key variables, such as
data on labor market conditions.
The reaction function relates to a key research interest of Ben McCallum's:
policy rules. Three key messages that McCallum stressed regarding rules have become
widely accepted.
The first message is that rules can be countercyclical. McCallum became
interested in policy rules at a time when those rules were closely associated with what is
termed "nonactivist" policymaking-defined as approaches that did not involve the
monetary authority responding to fluctuations in real variables such as output and
employment. At that time, the research literature focused on what was known as the k
percent rule, implying a fixed rate of growth for the money supply. This rule was
intended to pin down the longer-run inflation rate, but it precluded monetary policy
responses to the state of the business cycle. In contrast, McCallum, as well as other
economists of his generation such as Stanley Fischer and John Taylor, argued that it was
appropriate to consider both nonactivist policy rules and rules that were deliberately
countercyclical or activist.6 A policy rule, according to this view, could respond to
movements in output, employment, and inflation in a systematic way, using a formula
intended to be applicable over time and in different circumstances.7 Today it is widely
accepted by economists that monetary policy rules can be activist rules.
A second, related message of McCallum's work was that different rule
specifications can concretely characterize differences among economists on appropriate
monetary policy. In the 1970s, the whole notion of policy rules was closely associated
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with advocates of monetarism and rational expectations, with Keynesian economics
being seen as entailing opposition to policy rules. McCallum opposed this dichotomy
and observed, "To me it seems quite clear that debates between economists-for
example, Milton Friedman and James Tobin-are about the desirability of different
policy rules."8 That is, McCallum wanted to represent alternative perspectives on
monetary policy as different rule specifications, and he urged the study of rules as a
means of understanding various policy prescriptions and their consequences for the
economy. This perspective on rules has also become standard. Indeed, the box on
monetary policy rules that regularly appears in the Federal Reserve Board's Monetary
Policy Report provides a menu of policy rules designed to reflect a variety of views about
the appropriate formulation of monetary policy.9 Similarly, multiple rule prescriptions
and the possible implications of alternative rules for economic outcomes have, for many
years, been a regular part of the briefing materials that go to policymakers before each
FOMC meeting, allowing policymakers to incorporate these prescriptions into their
thinking and discussions.10
A third message of McCallum's work on rules was that there were merits in actual
policy following "rule-like" behavior.11 He recognized that policy rules were not likely
to be used literally or mechanically as a means of deciding on monetary policy actions.
Even so, McCallum believed that rules provided information about the responses to the
state of the economy that were likely to be associated with more successful
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policymaking. According to this reasoning, the prescriptions coming from policy rules
provide valuable benchmarks. As McCallum put it, "Actual central banks are unlikely to
officially adopt such rules, of course, but consideration of their implications could
nevertheless prove helpful in practice."12
McCallum also noted that this idea was strongly advanced by John Taylor in his
1993 paper introducing the Taylor rule.13 It's worth looking at some features of the
Taylor rule, as this will help bring out the connections between the policy rules literature
and Federal Reserve practice. My discussion of these features will underline the fact that
it is today widely accepted that the predictability of policymakers' reaction function
strengthens the stabilizing properties of monetary policy. In that sense, policymakers
understand the value of making decisions in "rule-like" ways.
First, I will discuss the Taylor rule formula's left-hand side-its specification of
the instrument. I will then turn to its right-hand side-the target variables to which the
instrument responds.
The Monetary Policy Instrument
As McCallum observed, "Taylor's paper (1993) succeeded brilliantly in
interesting central bankers in the consideration of rule-guided policy making."14 In
particular, Taylor's article helped bring monetary policy research into better alignment
with central bank practice in putting the focus squarely on interest rate rules. Much
monetary policy analysis in academia had considered rules in which the policy instrument
was a monetary or reserves aggregate. As I expect most of you know, this was a matter
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on which McCallum's research had two branches. On the one hand, the rule that
McCallum himself advanced in a number of papers in the 1980s and 1990s was a rule for
the monetary base and was designed to improve on the k percent monetary-growth rule
by introducing countercyclical responses and allowing for shifts in money demand.15
But, on the other hand, he also produced fundamental analytical work showing that
interest rate rules were viable, with his 1981 paper establishing that such rules could
provide an anchor on the economy's nominal variables.16 Consequently, McCallum was
receptive when the Taylor rule became a baseline reaction function in monetary policy
analysis.
Central banks were likewise receptive to the analysis of interest rate rules-and
the Taylor rule in particular. Their favorable reaction was driven by two factors. First,
after the experience of monetary targeting, central banks were disillusioned with policy
analysis that was focused on monetary aggregates. Second, interest rate rules were policy
relevant because these rules were expressed in terms of the short-term interest rate on
which central banks actually made decisions. As McCallum put it, "The fact is that
actual central banks in industrial countries conduct monetary policy in a manner that is
much more accurately depicted by writing [the interest rate] as the instrument."17
Reflecting this reality, all the rules considered in our Monetary Policy Report are interest
rate rules.18
Monetary Policy Targets
An additional attraction of the Taylor rule is that the right-hand-side variables
correspond closely to economic variables for which central banks have targets: inflation
and an estimate of the state of real aggregate demand or labor market conditions. I'll
make a few remarks about considerations related to these targets.
When it comes to the specification of the inflation term in a policy rule, in the
U.S. case, it's important that the inflation target is consistent with our dual mandate,
which includes a price-stability goal. In 1993, John Taylor suggested that a 2 percent
inflation objective characterized the Federal Reserve's behavior in the early Greenspan
years pretty well. This goal subsequently became official. In 2012, as I noted earlier, the
Committee made a goal of 2 percent inflation its formal interpretation of the price-
stability objective. The choice of a 2 percent longer-run goal reflected a broad consensus
that this rate corresponded to effective price stability in the United States. Around the
world, too, inflation-targeting central banks view 2 percent as the rate corresponding to
price stability. The FOMC has further judged that 2 percent is the inflation goal most
consistent with achievement of our dual mandate. We have reaffirmed this numerical
goal repeatedly since 2012, and, in tightening monetary policy since early last year,
we've made clear that we're determined to bring inflation down to 2 percent.
In considering the appropriate monetary policy response needed to return inflation
to 2 percent, I find it useful to draw on the findings of the policy rules literature. These
findings include the "Taylor principle" notion that deviations of inflation from target
should likely be met by a more than one-for-one response of the federal funds rate-a
response that helps ensure that the real interest rate is increased in policy tightenings.19
The other part of our dual mandate is the goal of maximum employment.
Reflecting the fact that this goal refers to the labor market rather than economic activity,
the interest rate rules considered in the Monetary Policy Report put the real target in
terms of an unemployment gap, rather than an output gap. On the matter of how this rule
should be used as an input into policymaking, the main thing that I would stress is that
there are multiple dimensions of labor market conditions, as well as considerable
uncertainty about the level of maximum employment. As a result, caution is justified in
having monetary policy responding to gap estimates. I therefore see merit in McCallum's
warning against monetary policy responding strongly to the output gap.20 In this
connection, Athanasios Orphanides's research suggests that estimates of the first
difference of economic slack (or excess demand pressure) may be less vulnerable to
mismeasurement than the corresponding estimates of the level.21 These considerations
imply that the prescriptions of the first-difference interest rate rule-which also appear in
the Monetary Policy Report-serve as a useful crosscheck on the prescriptions of more
standard variants of the Taylor rule.
Conclusion
Staying on the topic of policy targets, I think it is worth concluding by
emphasizing an important respect in which things have not changed since 1998 when Ben
McCallum reviewed monetary policy developments. He noted, "Overall, the most
fundamental change since the 1970s has been the assumption of responsibility by central
banks for performance in terms of inflation rates. In 1998, it would be extremely
surprising to run across a central bank statement that discussed medium-term inflation
prospects in a manner suggesting that these are unaffected by monetary policy
behavior."22 That difference between 1973 and 1998 is also an important contrast
between 1973, when U.S. monetary policy failed to play the part that it needed to play in
restoring price stability, and the FOMC's behavior over the past two years. Price stability
is a primary responsibility of the Federal Reserve. This is why we have taken forceful
steps aimed at reducing inflation-and why we will stay on the job to achieve our
objective.
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