In the months following the sharp stock market decline, it was unclear how rapidly economic activity was decelerating. Once it became clear, the Federal Reserve responded aggressively...On the other side, in light of the uncertain and attenuated pattern of recovery and expansion, the Federal Reserve has taken a gradualist approach to removing the monetary accommodation and returning to a more neutral policy stance.

First, it [gradualism] guides the economy in a particular direction but probably will not allow policymakers to overshoot the goal. Second, by moving slowly, policymakers have time to assess the effects of their actions on the economy and update their views on what further action needs to be taken.

In the months following the sharp stock market decline, it was unclear how rapidly economic activity was decelerating. Once it became clear, the Federal Reserve responded aggressively...On the other side, in light of the uncertain and attenuated pattern of recovery and expansion, the Federal Reserve has taken a gradualist approach to removing the monetary accommodation and returning to a more neutral policy stance.

The fact that there is uncertainty surrounding the state of the economy and new economic information becomes available on a nearly continuous basis supports the notion that it makes sense for policymakers to move in a slow and cautious manner.

As Chairman Greenspan has explained, monetary policymaking is risk management. The case for gradualism rests on the assessment that the cost of taking too large of an action is larger thn the cost of taking too small of an action. However, the story does not end here. While it is true that moving in a gradual manner reduces the chances of overshooting with all its attendant costs, the policymaker cannot afford to be consistently behind the curve. Given that monetary policy affects the economy with long and variable lags, there is a chance that by acting in this attentuated fashion we will undershoot the optimal policy stance. This can be at least as costly as overshooting. Our challenge is to weigh these costs and respond appropriately to the data and attendant risks involved. Our experience during the most recent business cycle underscores the need to be flexible in choosing the speed with which we respond to unfolding economic developments.

Specifically, Brainard showed that when policymakers are unsure of the impact that their policy actions will have on the economy, it may be appropriate for them to adjust policy more cautiously and in smaller steps than they would if they had precise knowledge of the effects of their actions. An analogy may help to clarify the logic behind Brainard's argument. Imagine that you are playing in a miniature golf tournament and are leading on the final hole. You expect to win the tournament so long as you can finish the hole in a moderate number of strokes. However, for reasons I won't try to explain, you find yourself playing with an unfamiliar putter and hence are uncertain about how far a stroke of given force will send the ball. How should you play to maximize your chances of winning the tournament?

How can the FOMC ensure that its policy actions feed into longer-term rates and thus influence the economy? An interesting result, noted in an early paper by Marvin Goodfriend (1991) of the Federal Reserve Bank of Richmond and developed more formally by my Princeton colleague Michael Woodford (2000, 2003), is that gradualist policies may allow the Fed to gain greater influence over long-term interest rates.3 The reason is the effect of past episodes of gradualist behavior on market expectations. In a gradualist regime, an increase in the federal funds rate not only raises current short-term rates but also signals to the market that rates are likely to continue to rise for some time. Because they reflect the whole path of expected future short-term rates, under a gradualist regime long-term rates such as mortgage rates tend to be relatively sensitive to changes in the federal funds rate. Thus, gradualism helps to ensure that the FOMC will have an effective lever over economic activity and inflation.

With respect to the strength of our responses to output gaps and inflation gaps, I think the Committee hasn’t been as gradual or as damped in its responses as the equations say it has. In my view there are a couple of points indicative of biases there. One is that the Committee has been forward-looking, so we’re really looking at forecasts and not at existing output gaps. We can often bring information to bear that says that a particular shock will likely go away and we don’t need to react so strongly to it.

So I think the wrong stuff is on the right-hand side of these Taylor rules; the Committee is doing much more than looking at the current levels of those two gaps. The second point is that these estimates are made on the assumption of a constant inflation target, in this case from 1987 through the present. I don’t want to get into a discussion of whether it should or should not have been constant. But I do believe that, from 1987 at least into the second part of the 1990s, the Committee surely did not have a constant inflation target. A number of the former members of this Committee talked about an opportunistic approach to reducing inflation. Inflation was higher than it needed to be over the long run, but there wasn’t any extraordinary effort to reduce it. The models wanted us to be stronger in reducing inflation because they had a lower inflation target than the Committee and the Committee didn’t react to the model’s target but to its own. I think that biases the results to finding that the Committee didn’t act as aggressively as the models thought it should, when in fact it acted fairly aggressively—and aggressively enough to get some pretty darn good outcomes for the economy over the past twenty years.

Having said that, I think there is a valuable lesson embedded here, and it goes to the discussion you were having about policy mistakes. It’s better generally for policy to act too strongly than too weakly to developing situations. Serious policy errors have been made when policy doesn’t react aggressively enough to a developing situation. Examples are the Federal Reserve in the 1970s or the Bank of Japan in the 1990s.

That is the sort of policy error that allows expectations to get out in front. It allows a spiral to develop that becomes very, very hard to reverse. If we react too aggressively, that also can be a policy mistake. But tightening too much because we’re afraid of inflation or easing too much because we’re concerned about deflation or recession is much more easily reversed without cumulating expectational problems getting built in. So to me the lesson for the Committee from these optimal rules is that we are probably better off being a little too aggressive than being not aggressive enough in terms of the possible consequences for the economy over time.

When inflation is already low and the fundamentals of the economy suddenly deteriorate, the central bank should act more preemptively and more aggressively than usual in cutting rates.  By moving decisively and early, the Fed may be able to prevent the economy from slipping into deflation, with the special problems that entails.