Firms, for their part, no longer have such liberal access to funds, so capital investment is more costly and difficult to support. The focus on immediate prospects for growth is what preoccupies many Fedwatchers, leading them to advocate further quick policy actions. They evaluate the case for funds rate movements in terms of the Taylor rule, a deceptively simple relationship between the funds rate, inflation, and real growth. Estimates of the economy s growth potential are more problematic and contentious, but most economists consider its current growth rate to be far below reasonable estimates. Since the Taylor rule suggests that the funds rate should decline in response to significant output gaps, many analysts call for further reductions.
Rules offer several advantages over pure discretion.
In particular, the Taylor approach to monetary policy is attractive because it limits the number of variables to be considered, it offers a simple method for balancing inflation concerns with concerns about economic growth, and it yields a numerical setting for the funds rate. Output gaps may be illusory because potential output cannot be estimated with confidence. Instead of gauging gaps in output, they may merely betray gaps in our knowledge. If the economy is currently growing more slowly than someone s idea of potential, it might well be because certain sectors are undergoing adjustments that simply need more time to work through. In some previous business cycles, policymakers exacerbated inflation by mistakenly responding to output gaps that subsequently proved insubstantial.