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Thursday, February 16, 2012

Evaluating the Current Stance of Monetary Policy Using a Taylor Rule

Marc Labonte
Specialist in Macroeconomic Policy

Oversight of the Federal Reserve’s (Fed’s) monetary policy decisions rests with Congress. But oversight is encumbered by the absence of a straightforward relationship between interest rates and economic performance. Further, the Fed’s policy decisions are discretionary, meaning there is no objective, transparent “yardstick” for evaluating their decisions. The Fed’s conventional policy tool is to target the federal funds rate, the overnight interest rate at which banks lend to each other. A simple rule of thumb guide to monetary policy decisions called a “Taylor rule” is an intuitive way to judge actual policy against some objective, albeit simplistic, ideal. Taylor rules prescribe a federal funds target based on inflation and the output gap (i.e., the difference between actual gross domestic product [GDP] and potential GDP) and can be adjusted to reflect a variety of policy goals.

The Fed eased monetary policy aggressively to counteract the recent recession and financial crisis and has kept a stimulative policy stance in place after the recession ended because of a persistently large output gap. This report compares current policy to a number of Taylor rules. Taylor rules take into account only a limited number of variables, which its proponents consider a strength, but its detractors consider a weakness. Since the Taylor rules considered in this report are based only on inflation and the output gap, they cannot consider other factors that might currently counsel in favor of the Fed’s “unconventional,” stimulative policy actions, such as the goal of stabilizing the financial system. This fact may explain why actual rates have been a little lower than what many Taylor rules currently prescribe.

Date of Report:
January 30, 2012
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Price: $29.95

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