their expectations and behavior in response to changes in monetary policy. fourth, with respect to the united states, the most popular versions of the taylor rule approximate how policy has evolved since the late 1980s – a period in which the federal reserve has been successful in keeping inflation in check ( figure 1 ). this suggests that policymakers, faced with the economic conditions of that period, weighted deviations from their goals in a manner similar to the weights used in these versions of the taylor rule. despite these attractive features, i do not believe that simple policy rules can take the place of in - depth analysis of economic conditions, evaluation of alternative policy plans, and ultimately policy judgment. while simple policy rules provide useful information to policymakers, their very virtue – simplicity – means they cannot capture all information that is relevant for policymaking. for example, such rules cannot easily incorporate asymmetric risks or financial stability issues. moreover, the usefulness of simple policy rules depends critically on the stability of the relationship between monetary policy and economic outcomes. if the relationship between in practice, so - called inflation - targeting central banks also tend to take into account employment and other aspects of the real economy ; hence, their approach is often referred to as “ flexible inflation targeting. ” more formally, a taylor rule can be represented as : ffr = r * + π + a ( π - π * ) + b [ 100 ( y - y * ) / y * ] where : ffr = federal funds rate r * = neutral real federal funds rate π = rate of inflation π * = target inflation rate y = output y * = output at full employment a = weight put on inflation gap b = weight put on output gap bis central bankers ’ speeches monetary policy and the real economy were stable over time, following a relatively simple and unchanging policy rule would likely generate acceptable results. however, if the linkage between monetary policy and the real economy is more variable, as i believe it is, then an approach that is more pragmatic and updates the policy setting in a clear and systematic manner based upon what the fomc learns over time will be more effective. in particular, a simple policy rule can generate poor macroeconomic outcomes when either the structure of the economy or the transmission mechanism of monetary policy changes in a significant way ( whether the change is temporary or permanent ). if private sector economic agents – workers, businesses, investors – thought we would implement a particular policy rule regardless of changes of these kinds, policy

welfare losses generated by deviations from the central forecast path symmetrically. but i don ’ t believe that the potential losses are currently symmetric. in my view, the distribution of potential outcomes is currently skewed to the downside, reflecting risks posed by developments in europe and the impending u. s. fiscal cliff. moreover, the costs associated with such downside outcomes are likely to be considerably higher than the costs of realizing upside surprises. for example, consider two alternative scenarios : an economy that grows very quickly, but starting with some genuine spare capacity, versus an economy operating way below potential that stagnates, pushing the united states into a liquidity trap. in the first case, we have good tools with which to respond. as the economy moved closer to full employment, we could raise short - term interest rates and subsequently sell assets from our portfolio. by doing this, we would tighten financial conditions, slow the economy and ensure it remained on a path consistent with our dual mandate objectives. the losses to society from this scenario should not be very large, provided we act in a manner that keeps medium - term inflation expectations in check. but the losses to society may be very high in the second case. that is because – as japan has discovered over the past two decades – once in a liquidity trap it is not easy to return to full employment and price stability. pinned at the lower bound, we don ’ t have as good a set of tools as we would ordinarily have to push the economy back toward our dual mandate objectives. as a result of this asymmetry, we should give somewhat more weight to avoiding the liquidity trap outcome. embedded within the traditional taylor rule formulations is the implicit return path back to full employment and price stability that the fomc achieved in the past when faced with shocks that pushed economic activity below its potential level. 14 obviously, there is a cost to those who are unemployed longer than necessary with no offsetting gain in terms of greater price stability. but there also is another potential long - run cost. those who have been unemployed for a long period of time may lose their job skills and become less employable in the future. this can push up the non - inflationary rate of unemployment ( nairu ). not only is this bad for those who are unemployed due to the loss of their job skills, it is bad for the nation as a whole because the rise in the nairu lowers the effective productive capacity of the economy and