overall inflation, and, through the effect of inflation on wage bargaining, impact on broader measures of price change in subsequent quarters. one way to handle that within the taylor rule is to specify the rule using a measure of core inflation, meaning one that excludes oil and food prices, the price components most subject to supply shocks. this will help policy to “ look through ” the initial burst of inflation, but it may fail to produce an appropriate immediate adjustment to counter the more permanent effect of the shock on inflation in subsequent quarters. another and perhaps better way to respond to supply shocks is to be forward looking and respond to forecasts of future inflation, rather than to the current inflation. this avoids both an overly aggressive response to the initial burst of overall inflation and an insufficient immediate response because of an inappropriate focus on a measure of inflation that ignores the current rise in oil prices. art and science work on policy rules and experience with implementing policy in an interest rate regime have, i believe, helped to define the set of principles i have just discussed. they are, i would remind you, only my perspective on the strategy of monetary policy, not official doctrine of the fomc. we have much to learn, both about the structure of the economy and about the best way to implement policy. the role of rules is best viewed in my judgment as informing the monetary policy decision, not dictating it. no single rule will be the best policy in all circumstances, as i hope i have demonstrated with my discussion. sometimes responding to recent trends in the data will work well, but sometimes a forward - looking policy will be critical, as might be the case in the current environment. sometimes an unusual circumstance will dictate a departure from what the rule might have suggested. an example here would be maintaining a very stimulative policy - - effectively a zero real federal funds rate - - during 1992 and 1993, a period well into the current expansion. this turned out, in my judgment, to be very excellent policy, though a departure from the taylor rule, because it took account of the unusual structural drags that were restraining the expansion and justified maintaining monetary stimulus longer than normal into an expansion. and, finally, monetary policy has to be sensitive to the potential for structural changes to alter fundamental relationships. science in the form of economic theory, econometric models, and carefully designed rules can improve the conduct of monetary policy. but good policy will always be, as alan holmes understood so well, a

for money will increase, putting upward pressure on interest rates. if the fed maintains an unchanged nominal interest rate target, it will have to add reserves to support a higher money supply at the initial interest rate. this means that, under a constant interest rate target, a demand shock would lead to perverse monetary policy, specifically to stimulative open market operations, reinforcing rather than damping the demand shock. the inherent danger in interest rate targeting is reinforced by the preference for central bankers for smoothing interest rates. this preference takes two forms. first, there is a preference for implementing a rise in rates in a series of small changes in the same direction. second, there is a reluctance to change the direction of policy, without particularly strong rationale. nevertheless, interest rate targets can, in principle, be implemented in a way that avoids this pitfall, and one of the values of rules is to remind policymakers of the importance of adjusting interest rates in response to changing economic conditions, thereby preventing policy from becoming destabilizing. - 7principles to guide the setting of interest rates we are now ready to identify a set of principles to guide decisions about the setting of the federal funds rate at fomc meetings. underlying these principles are the lessons gleaned from both the constant money growth rule and from the taylor rule. both rules highlight the importance of imposing a nominal anchor to pin down the long - run inflation rate and of varying real interest rates pro - cyclically to lean against the cyclical winds. the taylor rule also highlights the critical importance of real interest rates in the conduct of monetary policy. there is one very important difference between the constant money growth and taylor rules that deserves comment. while a constant rate of money growth will not always be optimal, if money demand is sufficiently stable, and not particularly interest sensitive, it will pin down inflation in the long run and help smooth the business cycle in the short run. that is, under a money growth target, doing nothing ( that is, maintaining an unchanged rate of money growth ) may not always be the best choice, but, for the most part, it won ’ t get you into serious trouble and will in fact do some considerable good, although it would likely involve a considerable variation in interest rates on a day - to - day basis. under an interest rate targeting regime, on the other hand, doing nothing can potentially get you into great difficulty - - sometimes quite quickly. in this case, policy must