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1 1 (July 9, 2014)

handle is hein.crs/govccvr0001 and id is 1 raw text is: Mon Monetary Policy and the Taylor Rule Some Members of Congress, dissatisfied with the Federal Reserve's (Fed's) conduct of monetary policy, have looked for alternatives to the current regime. H.R. 5018 would trigger congressional and GAO oversight when interest rates deviated from a Taylor rule. This In Focus provides a brief description of the Taylor rule and its potential uses. Normally, the Fed carries out monetary policy primarily by setting a target for the federal funds rate, the overnight inter-bank lending rate. The Taylor rule was developed by economist John Taylor to describe and evaluate the Fed's interest rate decisions. It is a simple mathematical formula that, in the best known version, relates interest rate changes to changes in the inflation rate and the output gap. These two factors directly relate to the Fed's statutory mandate to achieve maximum employment and stable prices. The best known version of this rule is: FFR = (R + I) + 0.5 x (output gap) + 0.5 x (I-IT) where: FFR = federal funds rate R = equilibrium real interest rate (assumed here to equal 2) output gap = percent difference between actual GDP and potential GDP I = inflation rate IT = inflation target (assumed here to equal 2) If actual GDP is equal to potential GDP and inflation is equal to its target, this rule calls for the federal funds rate to be 2% above the current inflation rate (because R = 2%). This is called the neutral interest rate, at which monetary policy is neither stimulative nor contractionary. The goal of achieving maximum employment is represented by the factor . 5 x (output gap). The output gap is the difference between actual and potential GDP. Potential GDP is the level of output that would be produced if all of the economy's labor and capital resources were being used. In economic downturns, actual GDP falls below potential because some resources are idle; likewise, the economy can temporarily be pushed above a level of output that is sustainable. In this rule, when the economy is below full employment, the output gap is expressed as a negative number, calling for lower interest rates. This Taylor rule states that when actual GDP is, say, 1% below potential GDP, the federal funds rate should be 0.5 percentage points below the neutral rate. Changes in inflation enter the Taylor rule in two places. First, the nominal neutral rate rises with inflation (in order to keep the inflation-adjusted neutral rate constant). Second, the goal of maintaining price stability is represented by the factor 0.5 x (I-IT), which states that the FFR should be 0.5 percentage points above the inflation-adjusted neutral rate for every percentage point that inflation (I) is above its target (IT), and lowered by the same proportion when inflation is below its target. Unlike the output gap, the inflation target can be set at any rate desired. For illustration, it is set at 2% inflation here, which is the Fed's longer-term goal for inflation. While a specific example has been provided here for illustrative purposes, a Taylor rule could include other variables, and any of the parameters (R, IT, and the weights on the output gap and inflation) could be set at any level. How Ae. CN N u 4.' nk U sed Taylor rules are currently used in economic analysis to explain the Fed's past actions or to offer a baseline in an evaluation of what the Fed has done or should do in the future. A Taylor rule (although with different parameters from this example) has been demonstrated to track actual policy relatively well for the period lasting from after inflation declined in the 1980s to the beginning of the financial crisis in 2007. Thus, it can be used in an economic model (which offers a simplified version of the actual economy) to represent the Fed's decisions under normal economic conditions. A limitation of the Taylor rule is that it was designed only to be used with the FFR, which was the Fed's primary monetary policy instrument from roughly the early 1990s to late 2008. Since December 2008, the Fed has not used the FFR as its primary policy tool because the FFR has been at the zero lower boundit has been set near zero, and thus cannot be lowered further. Instead, the Fed has created new policy tools to stimulate the economy. The Taylor rule cannot make policy prescriptions at the zero lower bound- different combinations of deflation (falling prices) and output gaps would prescribe a negative federal funds rate under the Taylor rule, but that prescription would not be actionable. The Taylor rule was devised at a time when interest rates had never fallen to the zero bound before, and it arguably seemed reasonable at the time to assume that the rule would not need to cover this contingency. Economists and policy analysts have debated whether basing monetary policy on a Taylor rule would lead to better economic outcomes than the status quo. Currently, Congress has granted the Fed broad July 9, 2014 .O 'T gognpo goo g , q 's a X 11LULANJILiN,

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