As my mother often told me when I was growing up, "The road to hell is paved with good intentions." Similarly, discretionary monetary policy, even though well intended, can lead to poor economic outcomes.

One important characteristic of simple rules is that they can be more easily explained to the public. That makes it easier for the public and for financial market participants to form expectations about policy. Simple rules could enhance the credibility of monetary policy, help anchor expectations, and better align the public’s expectations with the central bank’s intentions, which would minimize policy surprises and the detrimental effects often caused by such surprises.

One important desirable feature of simple interest rate rules such as Taylor’s is – it is a rule. That is, it systematically describes the behavior of policy. The advantages of simple rules are many. First, they are transparent, and allow for simple and effective communication of policy decisions. The result is that policymakers can more easily be held accountable and it is easy for the public and financial market participants to form expectations about policy. Thus, relying on simple rules enhances the credibility of monetary policy and helps anchor expectations. Second, when rules are simple and transparent, the public’s expectations are easily aligned with the Fed’s intentions, which minimize policy surprises and the detrimental effects often caused by such surprises. Thus, I place significant importance on systematic behavior both as a prescription for good policy and in terms of my own policy deliberations.

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The benefits of operating in an environment with the transparency afforded by simple rules is that it gives monetary policymakers the ability to anchor expectations and affords them the opportunity to temporarily deviate from the simple rules in extraordinary circumstances without eroding central bank credibility. We are now, perhaps, in a period of extraordinary circumstances and have deviated from the benchmarks suggested by simple rules. But such deviations should be temporary and limited and promptly reversed when conditions return to normal.

The idea that monetary policy should be conducted in a systematic and predictable way is not new. One of the earliest, and most controversial, proposals was Milton Friedman’s famous k-percent money growth rule.2 Friedman argued that monetary policy was a major contributor to cyclical fluctuations. He argued that efforts by the central bank to “stabilize” or “fine-tune” the real economy were fraught with danger because we didn’t know enough about the short-run dynamics of monetary actions to reliably predict their effects on the real economy. As a result, monetary policy ended up being a source of real instability rather than a stabilizing influence.

In addition, Friedman correctly argued that sustained inflation was always a monetary phenomenon and that in a world of paper or fiat money, the central bank had the obligation to preserve money’s purchasing power so that markets would not be distorted by inflation. Price stability would therefore promote a more efficient allocation of resources. At the time, this view of the importance of price stability was controversial, but today it is widely accepted.

Thus, Friedman highlighted two central features of good monetary policy that are hallmarks of the rules that I will turn to shortly. First, he argued that monetary policy should be formulated in a way that stabilized the purchasing power of money. Second, he stressed monetary policy should not be used to “fine-tune” real economic activity because attempting to do so often introduced instability into the real economy instead of improving economic performance. His actual proposal was that the Federal Reserve should announce that the money supply would be allowed to grow at k-percent a year -- period. With k a suitably low number, such a policy rule would ensure that inflation would never become a problem and that monetary policy would cease to be an independent source of cyclical fluctuations.

The Friedman rule is simple and easy to communicate. It also gives a high degree of predictability to monetary policy. Had it been implemented, it surely would have prevented the double-digit inflation the U.S. economy suffered in the late 1970s, as well as much of the subsequent economic disruptions in the early 1980s that occurred as inflation was brought back down to acceptable levels.

Yet the rule has several shortcomings that have limited its appeal. Most important, many economists view money demand as volatile, so that a constant supply of money could lead to more variability in inflation, and perhaps output, than necessary. Thus, most economists believe that some sort of policy that responds to the state of the economy could perform better.

Of course, even Taylor's research points out that periods of financial stress may require policy responses that differ from the usual prescriptions... The baseline outlook may be only modestly affected by the conditions, but there may be risks of substantial spillovers that could lead to persistent declines in credit intermediation capacity or large declines in wealth. These in turn would reduce business and household spending. In such cases, policy may take out insurance against these adverse risks and move the policy rate more than the usual prescriptions of the Taylor Rule.

Now if we took out such insurance too liberally or too often, then private sector markets would change their views regarding policy and alter their base level of risk-taking. But in doing so, we likely would observe inflationary imbalances emerging or unusual volatility in output. So part of our job as a central bank is to properly price these insurance premiums against the achievement of maximum employment and price stability over the medium term. Importantly, when insurance proves to be no longer necessary, removing it promptly and recalibrating policy to appropriate levels will reiterate and reinforce our commitment to these fundamental policy goals. And if we are transparent so that markets understand that we will adhere to this strategy, such insurance-based monetary policy will not encourage excessive risk-taking.

The Federal Reserve Act gives us broad authority to act in response to these types of conditions. We will continue to examine ways to adapt our instruments as market conditions evolve.  We will do so in close cooperation with other central banks, as indeed we have since August.  And we will do so in the tradition of pragmatism and flexibility that has been one of the defining features of the central bank of the United States.

For example, Bill wrote a Federal Reserve staff paper titled "Rules-of-Thumb for Guiding Monetary Policy" (Poole, 1971).  Because his econometric analysis of the available data indicated that money demand was more stable than aggregate demand, Bill formulated a simple rule that adjusted the money growth rate in response to the observed unemployment rate.  Bill was also practical in noting the pitfalls of mechanical adherence to any particular policy rule; in this study, for example, he emphasized that the proposed rule was not intended "to be followed to the last decimal place or as one that is good for all time [but] . . . as a guide--or as a benchmark--against which current policy may be judged" (p. 152).

The past decade has also witnessed significant progress in analyzing the policy implications of uncertainty regarding the structure of the economy...

Although Bayesian and robust-control methods provide insights into the nature of optimal policy, the corresponding policy recommendations can be complex and sensitive to the set of economic models being considered.  A promising alternative approach--reminiscent of the work that Bill Poole did in the 1960s--focuses on simple policy rules, such as the one proposed by John Taylor, and compares the performance of alternative rules across a range of possible models and sets of parameter values (Levin, Wieland, and Williams, 1999 and 2003).  That approach is motivated by the notion that the perfect should not be the enemy of the good; rather than trying to find policies that are optimal in the context of specific models, the central bank may be better served by adopting simple and predictable policies that produce reasonably good results in a variety of circumstances.

The last item on my list of limitations was that simple rules do not take account of risk-management considerations.  As shown in Figure 2A, the core CPI inflation rate for 2003 was falling toward 1 percent.  The real-time reading of the core PCE inflation rate (not shown) was on average even lower than the comparable CPI figure.  Given these rates, the possibility of deflation could not be ruled out.  We had carefully analyzed the Japanese experience of the early 1990s; our conclusion was that aggressively moving against the risk of deflation would pay dividends by reducing the odds on needing to deal with the zero bound on nominal interest rates should the economy be hit with another negative shock.  This factor is not captured by simple policy rules.

The first principle is that policy should be systematic and predictable. Remember that his famous paper was titled "Discretion versus Policy Rules in Practice" (Taylor, 1993b). This principle permeates the analysis and discussions at the Fed today. The Board staff regularly reports the policy prescriptions from estimated monetary policy rules, and the model simulations that are used to illustrate risks assume policy will respond according to an estimated policy rule. Of course, extraordinary or novel circumstances can arise where policy needs to deviate from its standard approach, but that should be the exception, not—so to speak—the rule.

The Taylor rule also embeds a basic principle of sound monetary policy that has subsequently been referred to as the Taylor principle.² According to this principle, when a shock causes a shift in the inflation rate, the central bank must adjust the nominal interest rate by more than one-for-one. This ensures that the real interest rate moves in the right direction to restore price stability. The Taylor principle provides essential guidance for central banks on how to anchor long-run inflation expectations and foster stable growth and low inflation.

Ever since its inception, John has emphasized that the Taylor rule should not be applied mechanistically. The world is far too complicated for that. But he has argued that such rules can serve as useful benchmarks for the practical conduct of monetary policy. In fact, policymakers at the Federal Reserve and many other central banks do routinely consult various policy rules as they make judgments on the appropriate stance of monetary policy.

I personally believe, and have so stated on numerous occasions, that the inflation goal should be quantified. I know that many disagree on this point. In today’s economy, I believe that a quantified inflation goal is not critically important but quantification might be of great importance in the future.

David suggests that monetarism failed when its proponents got too prescriptive by advocating rigid rules for money growth.  Among the lessons he takes from the failed monetarist experiment are that central banking is an applied science and that our imperfect understanding of how economies and markets function implies that a good dose of humility is required--and I agree. 

This conclusion came to be known as the "Taylor principle" (Woodford, 2001) and can be described most simply by saying that stabilizing monetary policy must raise the nominal interest rate by more than the rise in inflation. In other words, inflation will remain under control only if real interest rates rise in response to a rise in inflation. Although, the Taylor principle now seems pretty obvious, estimates of Taylor rules, such as those by Clarida, Gali, and Gertler (1998), indicate that during the late 1960s and 1970s many central banks, including the Federal Reserve, violated the Taylor principle, resulting in the "Great Inflation" that so many countries experienced during this period

My first principle is let markets work.  The second principle is the central bank has a responsibility to promote orderly conditions in financial markets, stepping in as necessary to avoid severe system disruption.  The third principle is to make sure the second principle doesn't undermine our long-term mission.

There are certainly tensions to be resolved in applying these principles, and formulating measured responses to circumstances requires good judgment, particularly in transitional periods.  I believe we are in such a period now.