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.

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.

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.

In particular, my views on the appropriate funds rate setting are and continue to be informed by Taylor-type monetary policy rules that depict the past behavior of monetary policy in response to deviation from its desired inflation target and economic activity from its natural or efficient level. I find such rules useful for benchmarking my policy prescriptions. These rules have been widely investigated and have been shown to be robust in that they deliver good results in a wide variety of models and circumstances.

The guidance I take from such robust rules is that we should no longer consider monetary policy as being constrained by the zero lower bound In fact, maintaining a funds rate target near zero is unprecedented under such circumstances and, as such, could pose risks to the economy in the years ahead, including higher inflation and financial instability.

The unemployment rate continues to improve more quickly than many had expected. We are now approaching the rate that many policymakers view as a long-run sustainable value. Further, numerous labor market indicators continue to show broad improvement and inflation is not appreciably below our 2 percent goal.

Beginning to raise rates sooner rather than later reduces the chance that inflation will accelerate and, in so doing, require policy to become fairly aggressive with perhaps unsettling consequences. Waiting too long to begin raising rates especially waiting until we have fully met our goals for maximum employment or attained our inflation target of 2 percent is risky because doing so could put monetary policy behind the curve. Such policies could lead to a return to abrupt go-stop policies, which in the past have led to unwelcome volatility. Finally, delay is likely to increase the risk of overstaying our welcome at the zero bound, thus fostering unintended consequences for financial stability.

HENSARLING: I will say this if I can, Madam Chair, there's one thing that the Fed says. It's another that markets may hear.
My time is running out. I want to cover a little other ground, as well dealing with a rules based monetary policy.
I think if I have read some of your statements properly -- and I don't want to put words in your mouth -- but that you consider times five years after the financial crisis still extraordinary, and it is not necessarily an appropriate time for a rules-based approach?
Is that a fair assessment of your views?
YELLEN: So I have always been in favor of a predictable monetary policy that responds in a systematic way to shifts in economic variables...
HENSARLING: Well, in fact, earlier in your career, with respect -- in reference to the Taylor rule you said it is, quote, "What sensible central banks do," unquote.
So that begs the question today, using your words, are you a sensible central banker, and if not, when will you become one?
YELLEN: Congressman, I believe that I am a sensible central banker, and these are very unusual times in which monetary policy for quite a long time is not even been able to do what a rule like the Taylor Rule would have prescribed. For several years, that rule would have prescribed that the federal funds rate should be in negative territory, which is impossible.
So the conditions facing the economy are extremely unusual.
I have tried to argue and believe strongly that, while a Taylor Rule is -- or something like it -- provides a sensible approach in more normal times, like the great moderation, under current conditions when this economy has severe headwinds from the financial crisis, and has not been able to move the funds rate into the negative territory that rule would have prescribed that we need to follow a different approach. And we are attempting, through our forward guidance, to be as systematic and predictable as we can possibly be.

By lowering private-sector expectations of the future path of short-term rates, this guidance can reduce longer-term interest rates and also raise asset prices, in turn, stimulating aggregate demand. Absent such forward guidance, the public might expect the federal funds rate to follow a path suggested by past FOMC behavior in "normal times"--for example, the behavior captured by John Taylor's famous Taylor rule. I am persuaded, however, by the arguments laid out by our panelist Michael Woodford and others suggesting that the policy rate should, under present conditions, be held "lower for longer" than conventional policy rules imply.

As always, monetary policy will need to evolve in response to ongoing shocks and new information. But I suspect that information about aggregate labor market quantities like unemployment will remain—at best—a noisy indicator about the appropriate stance of policy. Instead, I will be paying close attention to the behavior of core inflation. As the preceding analysis suggests, the changes in this variable appear to provide critical information about the empirical relevance of nominal rigidities, and therefore about the appropriate stance of monetary policy