One of the numbers in the Taylor Rule reflects Professor Taylor's estimate of what we sometimes refer to as the neutral level of the fed funds rate. 

It's a level of the fed funds rate that is consistent with the economy operating at full employment. And that's something that, by our estimate, has been very depressed in the aftermath of the financial crisis. Discussions about secular stagnation are very much about what is the level of interest rates that is consistent with the economy operating at full employment.

I'm hopeful that rate will rise over time, although I'm uncertain. But at the moment, most of the divergence between our settings and what would be the higher levels that would be called for merely reflect the headwinds facing the economy since the financial crisis.

So why don’t we just abandon these simple rules and embrace optimal control?

The answer is that, for all our intellect—and I’ll admit, economists are very sure their collective intellect is almost too much for the world to handle—there’s a limit to how much we truly know about the future. We have forecasts, which are based on sound data and analysis. But they’re only forecasts, and the unexpected can always erupt. I don’t have a 100 percent degree of certainty where housing prices are going. I don’t know for sure what’s going to happen with China. I wouldn’t bet my life on what the ECB or Bank of Japan is going to do. We may think we have it all figured out, but sometimes economists’ track records leave something to be desired. So there is a risk with the optimal control approach that we’ll believe our theories and our models too much, and that can lead us astray. There is a need for humility and to recognize our limitations.

What is important for attaining the Federal Reserve’s mandated objectives is not that monetary policy is described in terms of a formal prescriptive rule, but rather that the FOMC’s intentions and strategy are well understood by the public. This argues for clear communication through the FOMC meeting statements and minutes, the FOMC’s statement concerning its longer-term goals and monetary policy strategy, the Chair’s FOMC press conferences and testimonies before Congress, and speeches by the Chair and other FOMC participants. But it also is important that the strategy be the “right” reaction function. This means a policy approach that responds appropriately to important factors beyond the two parameters of the Taylor Rule—the output gap estimate and the rate of inflation.

There is a good bit of uncertainty right now, as you know, there's the debate between whether we've got an extended cyclical effect or whether there is some secular things going on in the economy that are changing growth potential and changing optimal policy. I don't think the FOMC is going to be able to disentangle that when -- before we have to make decisions. I do think under these circumstances it's probably wise not to be counting so much on past correlations, things like the Philips curve which haven't been operating effectively for ten years now. And instead to really look for some tangible evidence of, for example, hiccups in wages or inflation that allow us to make informed decisions based on the evidence.

I think we need a systematic policy, but I would strongly resist agreeing to follow any rule where the stance of monetary policy depends on only the current readings of two economic variables.

I will argue that in the U.S. context, a Taylor-type ruleeven an inertial oneis an incomplete guide for policy because it does not explicitly include financial variables that are important factors in the transmission of monetary policy to the real economy. Finally, I will briefly comment on the issue of secular stagnation and my views on the long-term equilibrium real federal funds rate.
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While simple policy rules provide useful benchmarks for policymakers, their very virtuetheir simplicityis also a significant shortcoming.

Accountabilityin any endeavor, including monetary policyis not about what actions have been taken. Rather, its about the results those actions achievespecifically, how well performance accords with the relevant objectives. Accordingly, my discussion of FOMC performance and plans is relentlessly goal-oriented.

My goal-oriented approach to FOMC accountability differs from the approach taken in legislation about monetary policy accountability that is currently under consideration by Congress. The Federal Reserve Accountability and Transparency Act (or FRAT Act) would require the FOMC to tell Congress and the public how the Committee plans to change the level of monetary accommodation in response to macroeconomic developments. A key element of the FRAT Act is a reference policy rule that would be intended to serve as a baseline for this communication. The rule frames accountability in terms of what choices the Committee is making, as opposed to how the macroeconomy is performing relative to FOMC objectives. In my discussion, Ill explain how this approach to accountability means that the reference policy rule in the FRAT Act would be likely to degrade, rather than enhance, the FOMCs ability to achieve its objectives.
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To be clear, the proposed legislation allows for the FOMC to deviate from the reference policy rule. However, the legislation views deviations from the reference policy rule as being undesirable. (In particular, it requires the FOMC to provide Congress with a detailed justification for any departure from the reference policy rule within 48 hours.) My point is that this perspective is flawed, because the reference policy rule does not allow for the possibility that the natural real rate of interest varies over time.

I don't believe that we need to follow rules mechanically. Judgment will always be required. Yet, policymakers and the public should be very cautious when they call for policy rates to deviate in significant ways from these guideposts. Making such judgments should require careful analysis, and the justification for deviating from the guidelines should be clearly communicated to the markets and to the public. Thus, policymakers will still be able to exercise discretion, but using rules as guideposts will enhance transparency and effective communication.
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[P]ublishing a monetary policy report with an assessment of the likely near-term path of policy rates, in conjunction with its economic forecast, would be a useful exercise and enhance communications. It would also provide added discipline for policymakers to stick to a systematic, rule-like approach. And it would force policymakers to think more deeply and systematically about policy and the justification for significant deviations from the guideposts.

Discretion is better than any rule in setting monetary policy

Kocherlakota laid out a detailed case for why rules-based interest-rate policies almost always fail to do a better job than flesh-and-blood central bankers. He said policy makers must consider information that cant be plugged into mathematical rules.

Kocherlakota said a rule-based approach would only work if it constrained a central bank that showed a clear bias toward letting inflation run too high.

In the U.S. there is little evidence of an inflationary bias by the central bank, he said.

Unfortunately, it is unlikely that policymakers will adopt a specific reaction function in the near term. Yet, there are numerous examples of such systematic approaches or reaction functions that can help us to gauge the stance of policy I frequently consider such reaction functions as I think about policy. These are typically Taylor-like rules named for the Stanford University economist John Taylor who first proposed them in the early 1990s. These policy rules typically call for the targeted funds rate to respond to deviations of inflation from some desired target and to deviations of output from some measure of potential sometimes referred to as economic "slack" or the "gap." Sometimes such gaps are translated into deviations from full employment.

These policy rules can offer useful guideposts for policymakers and the public in assessing the stance of monetary policy, and communicating more about such guideposts would enhance transparency and help make policy more systematic. Thus, there is no need to mechanically follow any particular rule, and judgment will always be required. Yet, policymakers and the public should be very cautious when they call for policy rates to deviate in important or significant ways from these guideposts. Making such judgments should require careful analysis, and the justification for deviating from such guidelines should be clearly communicated to the markets and to the public.

A monetary policy strategy such as I have just described could be communicated through a regular Monetary Policy Report, perhaps published quarterly. The report would offer an opportunity to reinforce the underlying policy framework of the Committee and how it relates to current and expected economic conditions.

Publishing a Monetary Policy Report with an assessment of the likely near-term path of policy rates, in conjunction with its economic forecast, would also provide added discipline for policymakers to stick to a systematic, rule-like approach. Communication about that path, in turn, gives the public a much deeper understanding of the analytical approach that guides monetary policy, thus making policy more transparent and predictable.

The second major implication is to be cautious about overreliance on simple monetary policy rules, such as the Taylor Rule, that do not include measures of financial market conditions in their formulation.

As I have noted elsewhere, the Taylor Rule formulation has a number of characteristics that make it a useful input into the policy-setting process

Despite these attractive features, I do not believe that simple policy rules can take the place of in-depth analysis of economic and financial market conditions. While simple policy rules provide useful benchmarks to policymakers, their very virtuetheir simplicityis also a significant shortcoming. Policy rules cannot capture all of the information that is relevant for policymaking. In particular, such rules do not capture the fact that the linkage between the federal funds rate and financial market conditions can be very loose.

...[M]onetary policy ultimately must be conducted in a pragmatic manner that relies not on any particular indicator or model, but instead reflects an ongoing assessment of a wide range of information in the context of our ever-evolving understanding of the economy.

I feel, Congressman, that it would be a grave mistake for the Fed to commit to conduct monetary policy according to a mathematical rule. No central bank does that.

And I believe that although under the legislation we could depart from that rule, the level of short-term scrutiny that would be brought on the Fed in real-time reviews of our policy decisions would -- would essentially undermine central bank independence in the conduct of monetary policy.

And I believe that global experience has shown that we have better macro-economic performance when central banks are removed from short-term political pressures and given the independence to, within a framework in which their goals are clear, and in our case those are specified by Congress, given operational independence, decide how to conduct monetary policy.

The Federal Reserve is the most transparent central bank, to my knowledge, in the world. We have made clear how we interpret our mandate and our objectives, and provide extensive commentary and guidance on how we go about making monetary policy decisions.

No central bank in the world follows a mechanical, mathematical rule, and I think it would be a terrible mistake to ask the Federal Reserve to specify a mathematical rule

If that's what you mean by your rule, a gold standard, a currency board, yes, that has happened, but given the goals that Congress has assigned to us with respect to inflation and employment, I'm not aware of any -- for example, an inflation- targeting country, of which there are many, that has a mathematical rule.

Nevertheless, it makes perfect sense to behave in a relatively systematic way, looking -- when you have objectives, asking the question, how far are you from achieving those objectives and how fast do you expect progress to be made in determining whether or not -- exactly how much accommodation is needed?

And a number of different factors come into play at different times. If we were following a specific mathematical rule, I really think performance in this recovery would have been dreadful. Most of the rules we would have used, first of all, we couldn't have followed in the depths of the downturn. They would have called for negative interest rates. And if we had tightened monetary policies, as some of those rules would have called for -- given the headwinds we face, the recovery would not be as far advanced as it is.

So there are special factors and structural changes that need to be taken into account that would make me very disinclined to follow a mathematical rule, but I think it is important that a central bank behave in a systematic and predictable way and to explain what it's doing and how it sees itself as likely to respond to future economic developments as they unfold. And that is precisely what we're trying to do with our forward guidance.