It is highly desirable that the central bank behave in a rule-like way, both for the political objective of the rule of law rather than the rule of men and because predictable policy promotes more efficient decisions in the private sector. To the maximum possible extent, we desire an equilibrium in which the markets behave as the central bank expects and the central bank behaves as the markets expect. Central bank behavior to anchor expectations of low and stable inflation is the single most important aspect of policy predictability. I believe that the Fed has come a long way in that direction though, obviously, there are certainly opportunities for the Fed to refine its policy rule. In this context, by “rule” I simply mean that the Fed’s policy actions are systematic and highly predictable responses to new information.

In answering audience questions earlier, Poole spoke about how observers can judge whether or not the Fed will intervene in economic crises. "The goal ought to be to be able to write something [rules for intervention] down in a formal fashion," Poole said. "We're not there yet but I'll tell you there's much more predictability than you might realize and ... there are events that can happen where you won't have any doubt as to how the fed is going to respond." He cited the failure of Long Term Capital Management and 9/11 as an examples where uncertainty was rampant and spreads "moved to a surprisingly large extent."

As reported by Market News

Let me be clear that I do want inflation to move down, but I believe policy may now be well-positioned to foster exactly such an outcome while also giving due consideration to the risks to economic activity.

I came to this conclusion by considering a variety of metrics that help assess the stance of policy. These measures include the forecast I have outlined today, as well as the recommendations from commonly used Taylor rules for monetary policy, named after John Taylor, a professor at Stanford who first suggested them. They give an estimate of an appropriate setting of the funds rate given where inflation is relative to an assumed target and a measure of tightness in goods or labor markets.

Taken as a whole, a variety of these rules indicate that the funds rate is currently within the moderately restrictive range that appears appropriate. Current conditions in goods markets generally suggest that the current policy stance is sufficient to bring inflation down to more acceptable levels.

[B]y a variety of measures, it appears that the current stance of policy will move inflation gradually back to the comfort zone while giving due consideration to the risks to economic activity. By a variety measures, I'm referring to my forecast that I have outlined today, as well as the recommendations from commonly used monetary policy rules that are used to gauge the stance of policy. Taken as a whole, these rules indicate that the funds rate is currently within the range that appears appropriate, given the current condition of the labor market and the position of inflation relative to my comfort zone.

Note that the target funds rate predicted by the Taylor formula generally tracks the actual funds rate through 2000, though there are sizable and persistent deviations of the funds rate from the values predicted by the formula. Nevertheless several of these episodes are consistent with a systematic monetary policy. First, in 1989 the FOMC increased the target funds rate more quickly than predicted by the formula suggesting that the Committee responded more vigorously to rising inflation than incorporated in the Taylor specification. Second, during 1990-91, the FOMC reduced the funds rate more quickly than predicted by the formula, suggesting a stronger response to the recession than incorporated in the Taylor specification. Third, between late September 1992 and February 1994 the target funds rate was held at a lower level (3 percent) than predicted by the Taylor specification. It was during this period that the FOMC expressed concern about “financial headwinds” that were restraining the recovery from the 1990-91 recession. Finally, in the fall of 1998 the FOMC lowered the funds rate when the Taylor specification predicted that the rate would be held constant. At this time, concern about financial stability figured strongly in policy deliberations in the wake of the Asian financial crisis, the Russian default and the near collapse of Long Term Capital Management, a large hedge fund.

The FOMC, and certainly John Taylor himself, view the Taylor rule as a general guideline. Departures from the rule make good sense when information beyond that incorporated in the rule is available. For example, policy is forward-looking, which means that from time to time the economic outlook changes sufficiently that it makes sense for the FOMC to set a funds rate target either above or below the level called for in the Taylor Rule, which relies on observed recent data rather than on economic forecasts of future data. Other circumstances—an obvious example is 9/11—call for a policy response. These responses can be and generally are understood by the market. Thus, such responses can be every bit as systematic as the responses specified in the Taylor rule.

http://www.stlouisfed.org/news/speeches/2006/08_31_06.html#fig1

First, in terms of policy actions, the Fed has become more systematic in its approach to maintaining price stability and promoting maximum sustainable employment. This systematic approach is well-described by the famous "Taylor Rule" (Taylor 1993). According to the Taylor Rule, an increase in inflation should consistently call forth a tighter monetary policy in the form of a higher real federal funds rate. In addition, the Fed should systematically tighten policy as labor market slack diminishes. Such a response serves to stabilize output and employment and also to preempt an increase in inflation. The experience of 1994 exemplifies the application of these principles: faced with declining unemployment and the prospect of an unwelcome increase in inflation, the Fed engineered a strong funds rate response. Because the Fed has been consistent in its approach, over time, market participants have come to observe its reaction to news and therefore better understand the determinants of policy. Therefore, this approach has enhanced the ability of financial markets to anticipate the policy response to economic developments.

For at least forty years economists have been trying to develop a quantitative characterization of FOMC policy actions—a policy reaction function.(5) A review published in 1990 analyzed 42 published examples of attempts at characterizing FOMC behavior. (6) Since 1993, the prevalent framework to quantify FOMC action is the “Taylor Rule.”(7)

None of these efforts have achieved their objective.(8) In my judgment, it is not possible at the current state of knowledge to define a precise reaction function of the FOMC, and perhaps it never will be possible.

It is possible, however, to describe some general principles that guide FOMC behavior and which can be applied by market participants to form expectations about how the FOMC will respond to new and unexpected information.

In an earlier speech, I referred to the policy framework that describes what I consider to be best-practice inflation targeting as constrained discretion.  Constrained discretion attempts to strike a balance between the inflexibility of strict policy rules and the potential lack of discipline and structure inherent in unfettered policymaker discretion. Under constrained discretion, the central bank is free to do its best to stabilize output and employment in the face of short-run disturbances, with the appropriate caution born of our imperfect knowledge of the economy and of the effects of policy (this is the "discretion" part of constrained discretion). However, a crucial proviso is that, in conducting stabilization policy, the central bank must also maintain a strong commitment to keeping inflation--and, hence, public expectations of inflation--firmly under control (the "constrained" part of constrained discretion). Because monetary policy influences inflation with a lag, keeping inflation under control may require the central bank to anticipate future movements in inflation and move preemptively. Hence constrained discretion is an inherently forward-looking policy approach.

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.

The uncertainties implicit in using any rule of thumb, however well it might have performed in the past, are probably sufficient that policy-makers should retain their discretion. There can also be periods when the Fed is pursuing multiple goals. At the same time, the science of rule-building may have advanced to the point where monetary rules of thumb might play some useful role in the conduct of monetary policy. Myriad short term uncertainties and special factors mean that rules still cannot deal with many ad hoc situations. But in view of the deeper uncertainties about how hard monetary authorities should lean against what wind, rules of thumb might give good guidance to policy-makers. They might help authorities avoid large and persistent mistakes. Rather than replacing judgment, in the end rules may aid judgment.

As Taylor himself has pointed out, these types of formulations are at best "guideposts" to help central banks, not inflexible rules that eliminate discretion. One reason is that their formulation depends on the values of certain key variables--most crucially the equilibrium real federal funds rate and the production potential of the economy. In practice these have been obtained by observation of past macroeconomic behavior--either through informal inspection of the data, or more formally as embedded in models. In that sense, like all rules, as I noted earlier, they embody a forecast that the future will be like the past. Unfortunately, however, history is not an infallible guide to the future, and the levels of these two variables are currently under active debate.

The focus on rules is much more important ...when the monetary aggregates, as has been the case for some time, do not bear a stable relationship to overall economic performance and therefore do not provide useful information about when and how aggressively to change interest rates. Taylor-type rules, in this environment, provide a disciplined approach to varying interest rates in response to economic developments that both ensures a pro-cyclical response of interest rates to demand shocks and imposes a nominal anchor in much the same way as would be the case under a monetary aggregate strategy with a stable money demand function. For this reason, I like to refer to the strategy implicit in such rules as "monetarism without money."

The staff has examined a number of alternative rules, including those based on monetary aggregates, commodity prices, exchange rates, nominal income, and, most recently, Taylor-type rules. ...

The focus on rules is much more important ...when the monetary aggregates, as has been the case for some time, do not bear a stable relationship to overall economic performance and therefore do not provide useful information about when and how aggressively to change interest rates. Taylor-type rules, in this environment, provide a disciplined approach to varying interest rates in response to economic developments that both ensures a pro-cyclical response of interest rates to demand shocks and imposes a nominal anchor in much the same way as would be the case under a monetary aggregate strategy with a stable money demand function. For this reason, I like to refer to the strategy implicit in such rules as "monetarism without money."