banks have adopted. reinforcing the trend to transparency, central banks have arguably become more systematic in their responses to the economy over the past several decades. systematic policy setting is easier to explain and anticipate and, as a consequence, helps to limit economic uncertainty associated with the conduct of monetary policy. a resurgence in interest and research about systematic approaches to monetary policy was sparked by the observation of john taylor, currently undersecretary of the department of the treasury, that the fomc's conduct of monetary policy since the late 1980s has been well explained by a simple formula, often called the taylor rule, that relates the level of the federal funds rate to the observed levels of the inflation and the unemployment rates. john taylor's keen insight was offered originally as a rough benchmark for policy and not as a binding, prescriptive " rule. " and, in fact, the difference between the actual setting of the federal funds rate and the taylor rule can be large at times, particularly at critical points when the economic outlook has changed suddenly. the part of policy not explained by the rule then reflects the large volume of information about the economy and its prospects that is not captured by current inflation and unemployment rates but that the fomc does take into account. the fomc uses all this information in an attempt to anticipate developments ; the taylor rule is backward looking. these differences between actual policy and policies predicted by a backward - looking rule also reflect our imperfect and constantly evolving understanding of the structure of the economy. the success of the taylor rule in capturing the broad contour of policy actions in recent years has prompted an enormous amount of economic research in search of refinements to or extensions of the original taylor rule that could provide an even more precise guide for central bankers - in effect, a rule that could serve as an " automatic pilot " for monetary policy. in my view, rules, including the taylor rule and its many variations, are useful benchmarks, but following an automatic policy prescribed by any pre - established rule would unnecessarily and undesirably limit the flexibility and judgment necessary in setting monetary policy. i have similar misgivings about other formulaic monetary policy proposals - sometimes referred to as strict inflation targeting - that would require the federal reserve to announce a numerical inflation target or range and conduct monetary policy at all times so as to keep actual inflation close to that objective. in effect, advocates of strict inflation targeting would have the central bank follow

, it does mean that losses will be incurred if volatility rises before the insurance expires. these non - traditional players may pull back from the market in such circumstances, exacerbating any rise in volatility when it finally eventuates. market liquidity one other factor which market participants are concerned about is the prospect that when a sell - off comes, the volatility and price movements will be exacerbated by the reduced capacity and inventory of market makers. that is, market liquidity is structurally lower now than it was in the past. the lower liquidity is not evident in a rising market when assets are being bought, but will quickly become apparent in a down market as investors try to exit their positions. it is true that there is not as much market - making capacity as prior to the crisis. there are various metrics that demonstrate this and there have been some well - publicised exits by various institutions from different markets. regulatory changes have, as intended, increased the cost of market - making, and hence shifted some liquidity risk to end investors. there have also been some strategic decisions taken by institutions and internal constraints have been imposed which have reduced capacity. the latter may have had at least as large an effect in reducing capacity as that of regulation. but it should be noted that the pre - crisis level of market liquidity was one where there was over - capacity, and hence not the benchmark to be regained. the question today is whether there is too little capacity. unfortunately, we won ’ t really ever know the answer to this question. when volatility returns, for a number of reasons, including those i have already mentioned, it may well rise quite rapidly. one thing i am sure of is that the spike in volatility will be blamed, rightly or wrongly, on regulation - induced reductions in market - making. but if we look back at previous market sell - offs, when market - making capacity was larger, we see that they were often quite violent too. market - makers can pull back in an environment of rapidly falling prices, either directly, or indirectly by significantly widening bid - offer spreads. market makers generally have just as much reluctance to catch a falling knife as any other market participant. they are after all intermediators of risk, looking to lay it off quickly, rather than being a warehouser of risk. bis central bankers ’ speeches the bond market sell - off in 1994 is a good example. (