05.27.10

### Economic Trends

# Monetary Policy and an Extended Period of Time

The FOMC met on April 27 and 28 and, like at previous meetings, continued to assert that the “Committee will maintain the target range for the federal funds rate at 0 to ¼” for an “extended period.” However, Thomas Hoenig dissented as he did at the previous meeting because he believed that “continuing to express the expectation of exceptionally low levels of the federal funds rate for an extended period was no longer warranted.”

Trying to figure out when the Committee should increase the funds rate is complex. But John Taylor in a seminal 1993 paper argued that a useful guidepost for conducting monetary policy can be given by a simple rule or strategy whereby the central bank sets the federal funds rate in response to two variables—inflation and deviations of output from potential output. He maintains that using such a guidepost constitutes good monetary policy, and furthermore that the rule is a good characterization of how the FOMC has actually set policy since 1987. The chart below estimates and plots a Taylor-type rule.

Clearly this is a guidepost, and the FOMC should and does consider a myriad of data when making decisions. Nevertheless, using this metric we ask whether conditions still warrant the extended period of time language, or whether the language should be weakened to indicate that a future rate hike may be more imminent.

While Taylor originally argued for policy to be set in response to inflation and the output gap, modifying the rule so that the funds rate also depends on the lagged funds rate fits the data better and, many believe, constitutes better monetary policy. There are two possible reasons for using such a rule (a type referred to as an inertial rule).

First, the inertial rule is one that can be thought of as a so-called partial adjustment rule—it characterizes the future path of the actual funds rate over the next several FOMC meetings. In other words, the Committee moves a fraction of the way to where the original non-inertial Taylor rule would suggest. A way to interpret the rule is that the Committee dislikes big movements in the funds rate and will avoid them. Clearly such a rule mimics the actual funds rate pretty closely.

According to this simple rule, policy is still constrained by the zero lower bound and therefore we should not have expected a policy increase before now. But what does this rule say about the likelihood of monetary policy going forward? To answer this question we extend the Taylor rule projections using Blue Chip consensus estimates about what output growth and inflation will be over the next year and a half. Assuming trend output growth is roughly 2.1 percent we can back out estimates of where this monetary guidepost suggests the funds rate will be in the next year and a half. According to this metric, the extended period of time language still seems appropriate. Even a very small rate increase (25 basis points) is probably three or more quarters away.

But these are just estimates given highly uncertain projections. Indeed, policy changes are based on many more factors not considered here. Similarly, there is lot of uncertainty about the size of today’s output gap and the forecast of the gap and inflation going forward. Because of this, many argue that the Taylor rule provides little guidance for monetary policy given the small discrepancy between the predictions of the rule and 50-75 basis points funds rate.

However, an inertial rule is also identical to one where the Committee is not simply responding to today’s inflation and today’s output gap, but one where the Committee takes into account past inflations and past output gaps as well. For example, the rule responds to today’s inflation directly, but yesterday’s funds rate in the rule can be thought of as responding to yesterday’s inflation. This process goes on, so that the rule is one where the Committee responds to a weighted average of past inflations and past output gaps. The weights decline the further back the rule looks. Given that policy is currently constrained by the zero lower bound, the policy implications of why monetary policy is inertial can be different.

As the name suggests, the zero lower bound refers to the fact that policymakers cannot lower rates any further, even though the Taylor rule suggests that rates should have been negative, and policymakers would most likely have preferred negative rates. If the lagged funds rate is important because it is a short-hand way of saying that policy responds to a weighted average of past inflations and past output gaps, today’s funds rate does not depend on yesterday’s funds rate, but what policy would have been if the zero lower bound were not present.

Thus, with a zero lower bound, the inertial rule is equivalent to another variation of the basic Taylor rule, one which is much more backward-looking. This backward-looking rule also suggests that it is likely to be an “extended period” before rates are increased. Indeed, according to this version of the rule, even a year from now we will still be more than a percentage point below where we should be. Another way of expressing this point is to say that even if our estimates of the output gap are 1 ½ percent lower, a policy increase is still one year away.