Abstract
The Federal Reserve has made substantial changes to its framework for monetary policy in recent years. On balance, the Federal Reserve has moved closer to the “flexible inflation targeting” used, in some form or another, by many foreign central banks. The Federal Reserve’s approach, however, includes a balanced approach to its dual objectives and uses a flexible horizon over which policy aims to foster its objectives. The paper uses a small-scale macro model to help illuminate the Federal Reserve’s use of forward guidance. It also examines the case for establishing a different policy objective, such as a higher inflation target or a nominal income target. The paper finds that such changes might be beneficial, but also have potentially significant drawbacks.
This is a preview of subscription content, log in via an institution to check access.
Similar content being viewed by others
Notes
See Svensson (2011) for a summary of the experience of inflation-targeting central banks.
Given space constraints, we do not analyze the Federal Reserve’s asset purchases; however, the working paper version of this article (English, López-Salido, and Tetlow, 2013) employs a simple, static model to outline the tradeoffs between the efficacy and costs of asset purchases.
The crisis and its aftermath also raised the issue of how central banks’ traditional monetary policy objectives can be integrated with their renewed interest in financial stability. The policy response to the crisis and its aftermath demonstrated the potential complementarities between regulatory and supervisory policies—including both prudential supervision and macroprudential policies—and “standard” monetary policy (see Bernanke, 2013c). A section of the working paper version of this article discusses how the tradeoffs between different policy objectives might be made and notes that, regardless of approach, there is a need for improved monitoring of financial markets and institutions to identify and address potential vulnerabilities. The working paper version also briefly discusses issues related to the appropriate institutional structure for the making of monetary policy and financial stability policy.
An example may help clarify the various components. In the case of a strict inflation-targeting central bank (which is likely only a caricature of inflation targeting in practice), the goal would be inflation at a particular numerical level at a particular horizon (perhaps 2 percent at a horizon of two years). The tool, at least in normal times, would likely be a target for a specific short-term interest rate, implemented through some standard set of market operations. The strategy for employing the tool might be a specific policy rule, such as the Taylor (1993) rule. Finally, the communications would prominently feature a regular “inflation report,” in which the central bank would report on inflation developments, explain any deviation from its target, and show how it planned to use its policy tool to return inflation to its target level over the required horizon.
We assume that the federal funds rate will trade near the target, while in practice actions taken by the Board of Governors and the open market desk are required to ensure that it does so. Henceforth, for brevity we will assume perfect control of the federal funds rate and so treat that rate as an instrument of policy, therefore omitting reference to “targeting” in this context.
For a summary of changes in FOMC communications from 1975 to 2002, see Lindsey (2003).
Many of the changes in communications reflected the work of the FOMC’s subcommittee on communications, headed by then-Governor Yellen.
Pre-1977, the Employment Act of 1946 established a dual mandate (with price stability defined as “maximum purchasing power”) for federal agencies generally.
As discussed in Mishkin (2007b), this mandate-consistent level of inflation is above zero because of measurement issues and the need to take into account the effects of very low inflation on the effective functioning of the economy as a result of the effective bound on nominal interest rates and downward nominal wage rigidity.
Of course, there is bound to be some imprecision in such interpretations because the SEP provides information on the range and central tendency of the individual economic and policy projections but does not link them for each participant. As a result, it may be difficult to interpret the projections in some cases. Moreover, the projections cover all Committee participants, without differentiating the Committee members.
For example, in the January 2009 SEP, the projections for overall inflation in 2011 had a central tendency of 0.9 to 1.7 percent, while the longer-run projections had a central tendency of 1.7 to 2.0 percent.
Hereafter, the “Statement.” The Statement has been reaffirmed, without material changes, at subsequent January meetings.
Since the preparation of this paper, the Federal Reserve has made further adjustments to its forward guidance. See Yellen (2014) for a discussion.
See Svensson (2013) for a recent discussion of forward guidance as a monetary policy tool with an application to the Swedish recent experience.
For a discussion, see the collected papers in the Taylor (1999a) volume.
This applies to prescriptions from a variety of monetary policy rules, including Taylor’s original 1993 rule and a later version he examined in Taylor (1999b).
See, for example, Meyer (2000) and more recently Kohn (2007).
Bernanke (2004) refers to this approach as “forecast-based targeting,” Svensson (2003, 2005) instead uses the term “targeting rules.” For a critical comparison with instrument rules, see McCallum and Nelson (2005).
That is, when projected employment is lower than its objective, then projected inflation should at some point be (temporarily) above target. It will not, in general, be optimal for both target variables to approach their targets from the same side. To be sure, the particular confluence of shocks that results in employment and inflation differing from their desired levels, together with the specific features of the model, could result in a period in which employment and inflation are on the same side of their targets, but so long as those shocks do not change the targets themselves, in New Keynesian models under rational expectations, it will be optimal for one of the two variables to overshoot the longer-run objective and approach from the other side. See Svensson (2011) for a detailed discussion.
Eggertsson and Woodford (2003) and Woodford (2011, 2012b) provide excellent discussions of the optimal policy under commitment in the presence of a zero bound constraint.
Nevertheless, at the other extreme, history-dependent strategies have been shown to perform very poorly in models in which expectations regarding interest rates or inflation are purely backward looking, such as in the widely analyzed simple model of Rudebusch and Svensson (1999).
Indeed, this “small FRB/U.S.” model was estimated by matching the impulse response properties of the rational expectations version of its larger sibling. See Appendix I and Brayton (2013) for details.
The model embeds a mixture of forward- and backward-looking elements influencing firm and household decisions, including price-setting based on a generalization of the quadratic adjustment-cost model of Rotemberg (1982) called polynomial adjustment costs; see, for example, Brayton and Tinsley (1996). The appendix summarizes the main features of the model including the characteristics of each of the simple rules used in the simulations.
It is computationally far less costly to use the small model than would have been the case for the large-scale nonlinear rational expectations version of the FRB/U.S. model. That said, for those experiments in which we conducted similar trials with the large-scale model, the conclusions were similar. This should not surprising given that the critical aspects of the monetary transmission mechanism in both—that is, the term structure of interest rates, price determination, and expectations formation—are quite similar.
The inertia might suggest that either policymakers prefer to avoid large changes and reversals in the policy rate, as a manifestation of committee dynamics (as in, for example, Riboni and Ruge-Murcia, 2008) or as something of a hedge against uncertainty and the policy errors that a less gradualist policy response might uncover. Inertial policy rules also have the feature that they are more reliably learnable than are static rules; see, for example, Bullard and Mitra (2002) and Tetlow and von zur Muehlen (2009). Alternatively, inertial rules might arise if the Committee were actually setting policy in a noninertial manner but responding to some persistent variable that was omitted from the rule. Rudebusch (2006) presents arguments and evidence against true inertia as the primary explanation. English, Nelson, and Sack (2003) argue that both inertia and other causes seem to be at work. Woodford (2003) emphasizes that inertia would be consistent with optimal policy in many models. Evidence suggests that each story plays some role, but we do not take a strong position on the source of this historical phenomenon.
The longer, working paper version of this article includes a fairly extensive analysis of the performance characteristics of a fourth rule, the first-difference rule. That rule does not depend on the level of the output gap or the level of the long-run real interest rate, but instead responds to the change in the gap and the inflation rate. The absence of level conditions in rules like the first-difference rule has been noted as a potentially attractive feature for reasons of robustness (see, for example, Orphanides, 2003). These results are omitted from this version for brevity.
The stochastic simulations use 5,000 bootstrapped draws from the model’s historical shocks drawn over a period from 1984:Q1 to 2012:Q4, subject to the same baseline as described in the text. The model is subjected to shocks for the period from 2013:Q3 to 2018:Q4, and simulated, under rational expectations, once for each of the 22 shocked dates to complete a draw. We assume that policy is implemented beginning in 2013:Q3, subject to the effective lower bound.
It is interesting and noteworthy that the rule that calls for the earliest departure under baseline conditions, the Taylor (1993) rule, is the one that has the smallest mass for departure for early dates. This is a manifestation of the rule’s low sensitivity to economic conditions, which means that it takes a less likely configuration of net positive real shocks to reduce the shadow price on the effective bound constraint to zero than is the case for, say, the Taylor (1999b) rule.
The working paper version of this article notes a high incidence of prescribed early departures from the ELB for the first-difference rule and a very high probability of return to the ELB, conditional on those early liftoffs. See English, López-Salido, and Tetlow (2013) for details.
Care needs to be taken in assessing the probability of return to the ELB for departure dates that are late in the period shown because the number of departures covered under these circumstances can be small, as indicated by the bars in the left-hand column of Figure 2.
Per-period losses are discounted with a quarterly discount factor of 0.99. As noted in Note 25, the presence of a penalty on the change in the federal funds rate can be justified on the grounds of a desire for robustness or simply as a preference of policymakers. In stochastic simulations of the FRB/U.S. model, the weight on this factor in the loss function produces variability in the funds rate that approximates the historical record, once one corrects for the low-frequency historical drift and volatility of inflation.
Measured by the same loss function used to construct the optimal policies, the rankings of policy rules under the baseline scenario, over the period from 2013:Q3 to 2018:Q4, from best to worst are as follows: commitment > discretion > inertial Taylor rule > Taylor (1999b) rule > Taylor (1993) rule.
The logic also underlies the proposal of Reifschneider and Williams (2000). These authors argued that in the aftermath of a prolonged period when the short-term nominal interest rate has been constrained by the ELB, the policy rate should be held lower for longer than would otherwise be suggested by the conventional rule in order to make up for past shortfalls in conventional monetary policy. By committing to such an approach, the central bank can provide additional accommodation while the funds rate is at its ELB.
See the longer, working paper version of this article, English, López-Salido, and Tetlow (2013), for a discussion of the performance of selected Taylor-type rules and the optimal commitment policy in an environment with a significantly larger, negative output gap.
Specifically, the inflation threshold is defined in terms of the eight-quarter-ahead projection of the trailing four- quarter rate of core PCE price inflation as forecast by the model. In the absence of future shocks, the inflation forecast will equal the actual future rate of inflation generated in the simulation and will be consistent with the current and projected future path for policy.
Other assumptions are possible, of course. One could assume that policy reverts to the simple rule gradually over time, for example. The approach taken here has the advantage of simplicity.
We warn the reader that this result is not general. There are combinations of models, baselines, and policy rules for which the adjustment of the inflation threshold would have a material effect on measured losses.
Measured using the same loss function as was used to construct the optimal policies, the rankings of the various threshold policies, with the inertial Taylor rule, for the baseline scenario as of 2018:Q4 are, from lowest loss to highest: commitment > discretion >5.5/2.5>5.0/2.5>6.0/2.5>6.5/2.5=6.5/2.0=6.5/3.0>6.5/1.5> no thresholds, where the first number in a pair is the unemployment threshold and the second is the inflation threshold.
The key result that welfare is improved by the use of thresholds in a high to very high proportion of draws holds up almost as well when the model is simulated assuming that agents form expectations using a small-scale VAR model, rather than model-consistent expectations. Details of these simulations are available from the authors upon request.
It seems reasonable to expect that a baseline in which the proportion of threshold crossings that arise from crossing the inflation threshold is higher would produce more draws where thresholds produce large gains. We have not formally tested this proposition, however.
The effect of thresholds is more substantial in terms of both the deferral of policy firming and the likelihood of returning to the zero lower bound for static policy rules like the Taylor (1993) and Taylor (1999b) rules because, as we have already shown, these rules tend to produce early firming and these often turn out to be deleterious for economic performance. For example, the 6.5/2.5 threshold pair improves welfare in 95 percent of draws for the Taylor (1999b) rule.
As noted above, the Committee has made further changes to its forward guidance after the preparation of this paper. Those changes included the inclusion of additional guidance regarding the path of the federal funds rate after liftoff. In particular, the statement indicates that “The Committee currently anticipates that, even after employment and inflation are near mandate-consistent levels, economic conditions may, for some time, warrant keeping the target federal funds rate below levels the Committee views as normal in the longer run” (see FOMC, 2014).
The working paper version of this paper includes a table summarizing unconventional monetary policies implemented by major foreign central banks to provide extra support to economic activity after reaching the effective lower bound on short-term policy rates. Additional unconventional policies have been announced since that paper was prepared.
The APP program covered a wide range of both public and private securities; purchases were unsterilized and concentrated in relatively short-term securities.
Importantly, the Bank of England stated that there is “no presumption that breaching any of these knockouts would lead to an immediate increase in the Bank Rate or sale of assets.” Thus the knockout conditions are thresholds, not triggers.
Even earlier, in June 2013, the Monetary Policy Committee used forward guidance to talk down longer-term U.K. interest rates that were coming under upward pressure in response to increases in U.S. yields following the June 2013 FOMC meeting, stating that “the implied rise in the expected future path of Bank Rate was not warranted by the recent developments in the domestic economy.”
Although refinancing operations are not identical to large-scale asset purchase programs, the two sets of policy actions have strong parallels, and the ECB’s massive and unsterilized LTROs have been credited for some of the same positive effects on financial markets, notably a reduction in peripheral-country interest rates (Rogers, Scotti, and Wright, 2013). The ECB also ran two covered bond programs between mid-2009 and late 2012, with cumulative purchases of €76 billion (¾ percent of GDP). More recently, the ECB has announced plans to purchase large amounts of private assets (ECB, 2014). Since the preparation of this paper, the ECB has also announced plans to purchase sovereign assets.
Indeed, to the best of our knowledge, only once has an inflation-targeting country raised its target without also changing the targeted variable. That was New Zealand in 1997 when it widened its inflation band from 0-to-2 percent to 0-to-3 percent.
Recently, Coibion, Gorodnichenko, and Wieland (2012) explicitly study, in the context of a modern macroeconomic New Keynesian model, the effect of the ELB on the optimal inflation rate, and they find that, for plausible calibrations, an inflation target around 2 percent is robustly optimal.
Indeed, VAR-based expectations are a standard assumption for simulations of the FRB/U.S. model, although rational expectations are also commonly assumed. See Brayton and Tinsley (1996) for a discussion.
Ascari and Sbordone (2013) provide a theoretical discussion of similar issues and emphasize that a permanently higher inflation rate will be associated with a more unstable economy and will tend to destabilize inflation expectations.
Revisions to nominal income were even larger in the late 1990s.
Indeed, when the FOMC discussed nominal income targeting at its November 2011 meeting, participants agreed that such a change was not advisable at that time because of the “significant challenges associated with the adoption of such frameworks” (FOMC, 2011b).
See, for example, Brayton and Tinsley (1996).
References
Ascari, Guido and Argia Sbordone, 2013, The Macroeconomics of Trend Inflation, Staff Report, No. 628 (New York: Federal Reserve Bank of New York.
Bank of England. 2013, Annual Report 2013.
Bank of Japan. 2006, “The Bank’s Thinking on Price Stability,” March 10.
Bank of Japan. 2012, “The Price Stability Goal in the Medium to Long Term,” February 14.
Bank of Japan. 2013a, “The “Price Stability Target” Under the Framework for the Conduct of Monetary Policy,” January 22.
Bank of Japan. 2013b, “Introduction of the ‘Quantitative and Qualitative Monetary Easing’,” April 4.
Bernanke, Ben S., 2004, “Inflation Targeting,” Remarks at Federal Reserve Bank of St. Louis, St. Louis, Missouri.
Bernanke, Ben S., 2007, “Central Banking and Bank Supervision in the United States,” Remarks at the American Economic Association Annual Meetings.
Bernanke, Ben S., 2012b, “Monetary Policy since the Onset of the Crisis,” Remarks at the Federal Reserve Bank of Kansas City Economic Symposium, Jackson Hole, Wyoming, August 31.
Bernanke, Ben S., 2013c, “A Century of U.S. Central Banking: Goals, Frameworks, Accountability,” Remarks at the conference, The First 100 Years of the Federal Reserve: The Policy Record, Lessons Learned, and Prospects for the Future, sponsored by the National Bureau of Economic Research, Cambridge, Massachusetts, July 10.
Blanchard, Olivier, Giovanni Dell’Ariccia, and Paolo Mauro, 2010, “Rethinking Macroeconomic Policy,” IMF Staff Position Note 10/03, (Washington, DC: International Monetary Fund, February).
Brayton, Flint, 2013, “FRB/US on Small Scale,” mimeo, Federal Reserve Board, Washington, DC, May.
Brayton, Flint and Peter Tinsley, eds., 1996, “A Guide to FRB/US: A Macroeconomic Model of the United States,” Finance and Economics Discussion Series Paper No. 1996-42 (Washington, DC: Board of Governors of the Federal Reserve System).
Bullard, James and Kaushik Mitra, 2002, “Learning About Monetary Policy Rules,” Journal of Monetary Economics, Vol. 49, No. 6, pp. 1105–1139.
Coibion, Oliver, Yuri Gorodnichenko, and Johannes F. Wieland, 2012, “The Optimal Inflation rate in New Keynesian Models: Should Central Banks Raise Their Inflation Targets in Light of the ZLB?,” The Review of Economic Studies, Vol. 79, No. 4, pp. 1371–1406.
Eggertsson, Gauti B. and Michael Woodford, 2003, “The Zero Bound on Interest Rates and Optimal Monetary Policy,” Brookings Papers on Economic Activity, Vol. 34, No. 1, pp. 139–211.
English, William B., J. David López-Salido, and Robert J. Tetlow, 2013, “The Federal Reserve’s Framework for Monetary Policy—Recent Changes and New Questions,” Finance and Economics Discussion Series Paper No. 2013-76 (Washington, DC: Board of Governors of the Federal Reserve System).
English, William B., William R. Nelson, and Brian P. Sack, 2003, “Interpreting the Significance of the Lagged Interest Rate in Estimated Monetary Policy Rules,” Contributions to Macroeconomics, Vol. 3, No. 1, article 5.
European Central Bank. 2011, “The Monetary Policy of the ECB”.
European Central Bank. 2013a, “Introductory Statement to the Press Conference,” August 1.
European Central Bank. 2014, “Introductory Statement to the Press Conference,” September 4.
Evans, George and Seppo Honkapohja, eds., 2001, Learning and Expectations in Macroeconomics. (Princeton University Press), January.
Federal Open Market Committee. 2009, FOMC Statement, March 18.
Federal Open Market Committee. 2011a, FOMC Statement, August 9.
Federal Open Market Committee. 2011b, Minutes from the FOMC meeting, November 1–2.
Federal Open Market Committee. 2012a, “Statement on Longer-Run Goals and Policy Strategy,” Press Release, January 25.
Federal Open Market Committee. 2012b, FOMC Statement, December 12.
Federal Open Market Committee. 2014, FOMC Statement, March 19.
Federal Reserve. 2011, Press release, March 24.
Fischer, Stanley, 1981, “Towards an Understanding of the Costs of Inflation: II,” Carnegie-Rochester Conference Series on Public Policy, Vol. 15, No. 1, pp. 5–41.
Fischer, Stanley, 2011, “Central Bank Lessons from the Global Crisis,” remarks at the Bank of Israel Conference on Lessons of the Global Crisis, Jerusalem, March 31.
Fischer, Stanley, 2013, “Macroprudential Policy: Israel,” Remarks at the Rethinking Macro Policy II: First Steps and Early Lessons conference, International Monetary Fund, April 16–17.
Fregert, Klas and Lars Jonung, 1999, Monetary Regimes and Endogenous Wage Contracts: Sweden 1908–1995. Stockholm School of Economics.
Galí, Jordi, 2008, “The New Keynesian Approach to Monetary Policy Analysis: Lessons and New Directions,” Universitat Pompeu Fabra Department of Economics and Business, Economics Working Papers, No. 1075.
Greenspan, Alan, 1988, Statement Before the Committee on Banking, Finance, and Urban Affairs, U.S. Senate, July 13.
HM Treasury. 2003, The Remit to the Monetary Policy Committee, December 10.
HM Treasury. 2013, Remit for the Monetary Policy Committee, March 20.
Kohn, Donald L., 2007, “John Taylor Rules,” Remarks at the Conference on John Taylor’s Contributions to Monetary Theory and Policy, Federal Reserve Bank of Dallas, Dallas, Texas, October 12.
Lindsey, David, 2003, “A Modern History of FOMC Communication: 1975–2002,” Board of Governors of the Federal Reserve System, Washington, DC, June 24.
McCallum, Bennett T. and Edward Nelson, 2005, “Targeting vs. Instrument Rules for Monetary Policy,” Federal Reserve Bank of St. Louis Review, September/October 2005, Vol. 87, No. 5, pp. 597–611.
Meyer, Laurence, 2000, “Structural Change and Monetary Policy,” Remarks before the Joint Conference of the Federal Reserve Bank of San Francisco and the Stanford Institute for Economic Policy Research, Federal Reserve Bank of San Francisco, San Francisco, California, March 3.
Mishkin, Frederic S., 2007a, “Monetary Policy and the Dual Mandate,” Remarks at Bridgewater College, Bridgewater, Virginia, April 10.
Mishkin, Frederic S., 2007b, “The Federal Reserve’s Enhanced Communications Strategy and the Science of Monetary Policy,” Remarks to the Undergraduate Economics Association, Massachusetts Institute of Technology, Cambridge, Massachusetts, November 29.
Orphanides, Athanasios, 2003, “Historical Monetary Policy Analysis and the Taylor Rule,” Journal of Monetary Economics, Vol. 50, No. 5, pp. 983–1022.
Reifschneider, David and John C. Williams, 2000, “Three Lessons for Monetary Policy in a Low-Inflation Era,” Journal of Money, Credit, and Banking, Vol. 32, No. 4, pp. 936–66.
Riboni, Alessandro and Francisco J. Ruge-Murcia, 2008, “The Dynamic (In)efficiency of Monetary Policy by Committee,” Journal of Money, Credit, and Banking, Vol. 40, No. 5, pp. 1001–32.
Rogers, John, Chiara Scotti, and Jonathan Wright, 2014, Evaluating Asset-Market Effects of Unconventional Monetary Policy: A Cross-Country Comparison, International Finance Discussion Papers No. 2014-1101 (Washington, D.C.: Board of Governors of the Federal Reserve System).
Romer, Christy, 2013, “It Takes a Regime Shift: Recent Developments in Japanese Monetary Policy Through the Lens of the Great Depression,” Speech given at the NBER Annual Conference on Macroeconomics, April 12.
Rotemberg, Julio J., 1982, “Sticky Prices in the United States,” Journal of Political Economy, Vol. 90, No. 6, pp. 1187–1211.
Rudebusch, Glenn D., 2006, “Monetary Policy Inertia: Fact or Fiction?,” International Journal of Central Banking, Vol. 2, No. 4, pp. 85–135.
Rudebusch, Glenn D. and Lars E.O. Svensson, 1999, “Policy Rules for Inflation Targeting,” in Monetary Policy Rules, ed. by J.B. Taylor (Chicago: University of Chicago Press), pp. 203–53.
Summers, Lawrence H., 1991, “How Should Long-Term Monetary Policy Be Determined? Panel Discussion,” Journal of Money, Credit, and Banking, Vol. 23, No. 3, Part 2, pp. 625–31.
Svensson, Lars E.O., 2003, “What is Wrong with Taylor Rules? Using Judgment in Monetary Policy through Targeting Rules,” Journal of Economic Literature, Vol. 41, No. 2, pp. 426–77.
Svensson, Lars E.O., 2005, “Targeting versus Instrument Rules for Monetary Policy: What Is Wrong with McCallum and Nelson?” Federal Reserve Bank of St. Louis Review, September/October 2005, Vol. 87, No. 5, pp. 613–25.
Svensson, Lars E.O., 2011, “Inflation Targeting,” in Handbook of Monetary Economics, ed. by Benjamin M. Friedman and Michael Woodford (North-Holland), 2010 Chapter 22, pp. 1237–1302.
Svensson, Lars E.O., 2013, “Forward Guidance as a Monetary Policy Tool in Theory and Practice: The Swedish Experience,” paper presented at the NBER Conference “Lessons from the Financial Crisis for Monetary Policy”, Boston, October 18–9.
Taylor, John B., 1993, “Discretion versus Policy Rules in Practice,” Carnegie-Rochester Conference Series on Public Policy, Vol. 39, No. 1, pp. 195–14.
Taylor, John B. ed. 1999a, Monetary Policy Rules. University of Chicago Press.
Taylor, John B. ed. 1999b, “A Historical Analysis of Monetary Policy Rules,” in Monetary Policy Rules. University of Chicago Press, pp. 319–48.
Taylor, John B. and John C. Williams, 2011, “Simple and Robust Rules for Monetary Policy,” in Handbook of Monetary Economics, ed. by Benjamin M. Friedman, and Michael Woodford (North-Holland), Chapter 15 pp. 829–59.
Tetlow, Robert J. and Peter von zur Muehlen, 2009, “Robustifying Learnability,” Journal of Economic Dynamics and Control, Vol. 33, No. 2, pp. 296–316.
Woodford, Michael, 2003, Interest and Prices: Foundations of a Theory of Monetary Policy (Princeton: Princeton University Press), August 18.
Woodford, Michael, 2011, “Optimal Monetary Stabilization Policy,” in Handbook of Monetary Economics, ed. by Benjamin M. Friedman and Michael Woodford (North-Holland), Chapter 14, pp. 723–828.
Woodford, Michael, 2012a, “Inflation Targeting and Financial Stability,” NBER Working Papers, No. 17967 (National Bureau of Economic Research).
Woodford, Michael, 2012b, “Methods of Policy Accommodation at the Interest-Rate Lower Bound,” paper presented at the Federal Reserve Bank of Kansas City Symposium on The Changing Policy Landscape, Jackson Hole, Wyoming, August 31.
Yellen, Janet L., 2012, “Revolution and Evolution in Central Bank Communications,” Speech given at the University of California Haas School of Business, Berkeley, California November 13.
Yellen, Janet L., 2014, “Transcript of Chair Yellen’s Press Conference,” March 19.
Additional information
*William B. English is Senior Special Advisor, Office of Board Members, Board of Governors of the Federal Reserve System. J. David López-Salido is Deputy Associate Director, Division of Monetary Affairs, Board of Governors of the Federal Reserve System. Robert J. Tetlow is Advisor, Division of Monetary Affairs, Board of Governors of the Federal Reserve System. The authors are grateful for the comments and feedback of Jim Clouse, Chris Erceg, Jon Faust, Etienne Gagnon, Thomas Laubach, Michael Kiley, Steve Meyer, Ed Nelson, Joyce Zickler, our discussant, Christy Romer, two anonymous referees and the editors, Pierre-Olivier Gourinchas and Ayhan Kose. All remaining errors are those of the authors. They also thank Luke Van Cleve for expert computational assistance and Timothy Hills and Jason Sockin for help editing text and figures.
Appendices
Appendix I
The “Small FRB/U.S.” Model
The model employed in this paper is a small-scale version of the Board staff’s FRB/U.S. model. As documented in a sequence of papers,Footnote 54 FRB/U.S. can be described as an elaborate, large-scale version of a New Keynesian model. The larger model contains structures designed to allow the model to consider a wide range of economic phenomena, consistent with its role as the central domestic-economy model in much Federal Reserve Board staff analysis. However, for the class of experiments of interest in this paper—experiments that center on the monetary transmission mechanism in general and expectations formation in particular—a much simpler model can capture the essence of the FRB/U.S. model.
As in the original model, agents in what we might call “small FRB/U.S.” formulate decision rules by choosing a target path for the decision variable of interest, subject to an adjustment cost function. Small FRB/U.S. condenses the decisions of a variety of agents into a single decision maker who can be thought of as choosing a target path for consumption, to minimize an adjustment cost function. The order of adjustment costs is a generalization of the well-known quadratic-adjustment cost model as exemplified by Rotemberg (1982) for the case of monopolistically competitive price-setting agents. The order of adjustment costs could be as high as three; however, the key behavioral equations of the FRB/U.S. model and hence, of small FRB/U.S., involve second-order adjustment costs, which means that it is costly to adjust the growth rate of the decision variable. For a generic variable, x t the (second-order) cost function is as follows:
where β is the discount factor, b 1, b 2 are adjustment cost parameters, and an asterisk indicates a desired or target level of a variable. The solution to the above problem results in a decision rule, which can be written in extended error-correction form:
where z t is the weighted sum of expected future changes in the target variable along the desired path toward steady-state equilibrium. Without the z-variable, Equation (A.2) is a straightforward error-correction equation; it captures all the forward-looking aspects of the agent’s decision making. As befits their structural nature, the z-variable embeds cross-equation restrictions from the adjustment cost technology, and is written in this second-order adjustment-cost case as:
Note that first-order adjustment costs obtains as a special case when λ2=0 in which case z t+2 and Δx* t+1 drop out.
For small FRB/U.S., we can think of the two decision variables covered by this formulation as consumption and the consumption price level; monetary policy is taken as being governed by any of the several Taylor-type rules described in Appendix III, or by an optimal control policy.
Let us take x to be the output gap (gap in what follows), with target, gap*. The target paths—that is, the z-variables—that enter the dynamic adjustment equations for the output gap equation are as follows:
Equation (A.4) shows that the desired output gap, conditional on adjustment costs, is a function of the deviation of the target level of the long-term real interest rate, rrl t , from its equilibrium level, and a weighted average of the current output gap and a geometric sum of future output gaps, gap pv where the pv superscript indicates a present value of, in this case, expected future output gaps. This present-value calculation is specified in Equation (A.6). Equation (A.5) models the long-term real interest rate as a geometric sum of short-term real interest rates plus an output gap term; the latter captures the relationship between term premiums and the state of the economy. The presence of the gap pv reflects the role of permanent income in consumption, while rrl−rrl ∞ captures the wealth and substitution effects of interest rates on desired consumption; see, Brayton (2013) for further details.
The model’s price equation resembles a standard hybrid New Keynesian specification with a coefficient on lagged inflation and unity minus that coefficient on lagged inflation, plus a term in the output gap. The only nonstandard element to it is that a term in the change in the (long-term) real interest rate appears as a proxy for (temporary) exchange-rate effects on domestic prices operating through uncovered interest parity with the foreign interest rate taken as exogenous. This term plays no significant role in what is studied in this paper.
Finally, we add an expression linking the unemployment gap to the output gap, that is, a dynamic Okun’s Law equation:
Here is the complete model (except for the monetary policy rule) with numerical values for the coefficients. Expectations operators and constant terms are suppressed.
Appendix II
The Baseline
As noted in the main text, the quantitative results described in this paper will exhibit some sensitivity to the particular features of the baseline owing, among other things, to the implications of the ELB. Accordingly, in this brief appendix, we describe in words the central features of the baseline. It should be noted that the qualitative results will not differ substantially for alternative baselines that are in the neighborhood of one described here.
The construction of the baseline begins with the National Income and Product Accounts for 2013:Q2, as they were seen in July 2013, together with a characterization of the state of resource utilization that is consistent with those accounts. All of the scenarios described in this paper begin in 2013:Q3. In our baseline, we assume that the output gap is −2.8 percent as of that date, and the unemployment rate is 7.5 percent, which with a natural rate of unemployment of 5½ percent corresponds to an unemployment gap of 2 percentage points. The output gap is assumed to close slowly over time, reaching zero at the end of 2018; the labor market gap closes at about the same date. Inflation as measured by the four-quarter rate of change in core PCE prices is 1.1 percent in 2013:Q3 and climbs slowly to reach the target rate of inflation of 2 percent in 2020. The path for the federal funds rate that supports this outlook remains at the effective lower bound until the first quarter of 2016 after which it climbs moderately quickly, reaching 4 percent in 2021.
Appendix III
The Simple Monetary Policy Rules
The table below gives the expressions for the policy rules used in this paper. In the table, R t denotes the nominal federal funds rate for quarter t, while the right-hand-side variables include the model’s projection of trailing four-quarter core PCE inflation for the current quarter and three quarters ahead (π t and π t+3|t , respectively), the output gap estimate for the current period as well as its one-quarter-ahead forecast (gap t and gap t+1|t ), and the forecast of the three-quarter-ahead annual change in the output gap (Δ4 gap t+3|t ). The value of policymakers’ long-run inflation objective, denoted π*, is 2 percent. The nominal income targeting rule responds to the nominal income gap four quarters ahead, which is defined as the difference between nominal income yn t (100 times the log of the level of nominal GDP) and a target value yn* t (100 times the log of target nominal GDP). Target nominal GDP in 2007:Q4 is set equal to actual nominal GDP in that quarter and then projected forward at a rate of 2 percentage points per year faster than conventional estimates of potential GDP, about 2½ percent per year.
The first two of the selected rules were studied by Taylor (1993, 1999a and 1999b). The inertial Taylor (1999a and 1999b) rule is a straightforward extension of the Taylor (1999a and 1999b) rule. The long-run real interest rates appearing in the Taylor (1993, 1999a and 1999b) rules and the inertial Taylor (1999a and 1999b) rule are set a bit over 2 percent.
Rights and permissions
About this article
Cite this article
English, W., López-Salido, J. & Tetlow, R. The Federal Reserve’s Framework for Monetary Policy: Recent Changes and New Questions. IMF Econ Rev 63, 22–70 (2015). https://doi.org/10.1057/imfer.2014.27
Published:
Issue Date:
DOI: https://doi.org/10.1057/imfer.2014.27