The Road to Normal: New Directions in Monetary Policy

Annual Report 2015 | Federal Reserve Bank of St. Louis

The Road to Normal

Why Normalize?

Click on the terms in bold to see their definitions in the Glossary below.

As discussed above, the Fed’s monetary policy decisions are made in the context of the dual mandate, which comes from Congress. Normalization, if it is a good idea, should improve the Fed’s ability to achieve its 2 percent inflation goal and maximum employment in the future. There are strong arguments that normalization is indeed a good idea; those arguments typically take two different forms: the New Keynesian view and the Neo-Fisherian view. These two views invoke the ideas of two highly prominent economists from the early 20th century, John Maynard Keynes and Irving Fisher.

The New Keynesian View

John Maynard Keynes

John Maynard Keynes*

New Keynesian (NK) ideas are a synthesis of the modern macroeconomic ideas that have been introduced in the past 45 years and older Keynesian ideas. Modern macroeconomics has emphasized the use of economic theory in macroeconomics, the role of forward-looking economic behavior and the importance of commitment by economic policymakers; older Keynesian ideas date back to Keynes’ General Theory of Employment, Interest, and Money of 1936. NK economics was laid out in detail by Michael Woodford in 2003, and these NK ideas have been developed in the form of quantitative macroeconomic models that are widely used by central banks.12

In basic simplified New Keynesian macroeconomic models, there are three economic relationships: (i) an IS curve that describes the relationship between expected output growth and the short-term interest rate; (ii) a Phillips curve, capturing a positive relationship between aggregate economic activity and the rate of inflation; and (iii) a Taylor rule, which describes how the central bank chooses its target nominal interest rate in response to observed inflation and unemployment.13 Basically, the Taylor rule states that the Fed’s nominal interest rate target should increase when inflation rises relative to its target, and the target nominal interest rate should decrease if unemployment rises relative to the unemployment rate consistent with “full employment.”14 This formally captures a policy rule reflecting the Fed’s dual mandate—under the Taylor rule, the Fed ultimately cares about hitting an inflation target (2 percent per year) and an unemployment rate target. Then, it changes its nominal interest rate target to move the economy as close as possible to its ultimate targets, in a well-defined sense.

A Taylor rule actually fits reasonably well the historical behavior of the Fed. Figure 8 shows the fed funds rate, and the predictions of a Taylor rule fit to the data from 1987:Q4 to 2007:Q4.

Figure 8

Figure 9 shows what would have happened if the Fed had behaved as it did during the period starting in 1987 and ending in 2007, when the Great Recession started. The figure shows the actual fed funds rate and the rate predicted by the Taylor rule, given the actual inflation rate and unemployment experienced from 2008 on. The Taylor rule predicts a negative fed funds rate for the period from the end of 2008 to the beginning of 2011. Because the fed funds rate cannot be negative, we can interpret this period as one in which the predicted fed funds rate is zero, given this Taylor rule. Thus, from late 2008 to early 2011, the Fed conformed to its previous behavior—if it could have achieved negative fed funds rates it would have done so, but this was not feasible.

However, Figure 9 shows the fed funds rate predicted by the Taylor rule rising above the actual fed funds rate in early 2011. If the Fed had been behaving in a pre-Great Recession fashion, liftoff would have occurred in early 2011, and the fed funds rate would currently be above 2 percent rather than where it is—in the range of 0.25-0.5 percent.

Figure 9

Thus, an argument in favor of liftoff and normalization of monetary policy is:

  1. Monetary policy in the period 1987-2007 was successful at achieving the Fed’s goals. Inflation was low and stable, and the recessions in 1990-1991 and in 2001 were relatively mild. Thus, conducting monetary policy as was done from 1987 to 2007 should produce good results.
  2. The Great Recession may have been an extraordinary event, but if monetary policy had been conducted in the way it had been in the 1987-2007 period, then liftoff would have occurred in 2011. Thus, starting on the path to normalization in December 2015 was not premature—it was long overdue.

A counterargument is that the Fed was very close in late 2015 to achieving its goals. Figure 10 shows the 12-month percentage increase in the PCE deflator and in the PCE deflator excluding food and energy prices (or core PCE). Although both of these measures had been below the Fed’s 2 percent target since early 2012, and the December 2015 measure for PCE inflation was 0.6 percent, we could argue that this recent low inflation was due to temporary factors—principally the large drop in oil prices that occurred in 2014 and into 2016. If we strip out food and energy prices, the core PCE shows 1.4 percent inflation for December, which is much closer to the 2 percent target. As well, the unemployment rate, at 5 percent for the last three months of 2015, was at the Congressional Budget Office’s estimate of the natural rate of unemployment.

Further, a New Keynesian might argue, based on Phillips curve logic, that we should expect inflation to increase as the unemployment rate continues to fall. Thus, the Fed was very close in late 2015 to hitting its policy targets and should have come even closer in the immediate future without taking any policy action. According to this counterargument, we did not need to adhere to policies that worked in the past if current policy seemed to be doing fine.

Figure 10

The Neo-Fisherian View

Irving Fisher

Irving Fisher**

The Neo-Fisherian view is based on the relationship between inflation and nominal interest rates. As an aid in understanding the basic forces at work, suppose I am considering whether to acquire a particular asset. If the nominal interest rate I will receive from holding the asset is R, and the inflation rate over the period I hold the asset is i, then the real interest rate, that is, the real rate of return I receive on the asset, is R – i. However, at the time I acquire the asset, I do not know what the future inflation rate will be. In making my decision, I will make a forecast of inflation, i e (my expected inflation rate) and base my decision about holding the asset on the expected real interest rate R – i e.

Though there is sound macroeconomic theory and empirical evidence supporting the idea that monetary policy can affect real interest rates and real aggregate economic activity over the short run, that theory and empirical evidence also tell us that monetary policy has no effects on real interest rates in the long run. Therefore, for example, if the Fed lowers the nominal interest rate permanently, in the long run this will have the effect of leaving R – i and R – i e unchanged, that is, a permanent reduction in the nominal interest rate simply reduces the inflation rate and expected inflation by the same amount, in the long run. This is called the Fisher effect: High (low) nominal interest rates tend to be associated with high (low) inflation.

Figure 11 shows a scatter plot of the 12-month inflation rate in the United States versus the fed funds rate for the period 1954-2015. In the figure, we can observe a strong positive correlation, consistent with the Fisher effect. Note the recent observations, since the end of 2008, when interest rates were very low; they are a cluster of points in the lower left of the scatter plot.

Figure 11

Recognizing the Fisher effect as an important force helps us understand what is going on in episodes where ZIRP has persisted for a long time. For example, Japan has had ZIRP (or very close to ZIRP) for about 20 years and has also experienced an average inflation rate of about zero over that period. It should not be surprising that inflation is low in the United States after seven years of ZIRP. Similarly, the low inflation and low nominal interest rates we currently see in the euro area, Switzerland, the U.K., Denmark and Sweden, among other countries, are consistent with a manifestation of the Fisher effect.

Recall that a counterargument (earlier) to the New Keynesian view for normalization is that, under the monetary policy settings prior to mid-December, the Fed was close to achieving its goals, with the only problem being that inflation was a bit on the low side. Further, according to the counterargument, the Phillips curve tells us that additional tightening in the labor market should have caused inflation to increase. But how has the Phillips curve been doing lately? Figure 12 shows a post-Great Recession scatter plot of the inflation rate versus the unemployment rate for the United States, with the line joining the points in sequence, from 2009:Q3 on the far right to 2015:Q4 on the far left. Instead of a Phillips curve with a negative slope, what we have observed is a positively sloped Phillips curve. As unemployment has been falling, so has the inflation rate.

Figure 12

It would, therefore, be surprising if the Phillips curve were to suddenly reassert itself (in the form of higher inflation) after this long period of falling unemployment and falling inflation, particularly in light of the long experience with ZIRP in Japan. While the Phillips curve is nonexistent in the recent U.S. data, it is also hard to find over other time periods and in other countries, as well. The Fisher effect, which we can see plainly in Figure 11, is a strong regularity across time periods and countries. An element of the Neo-Fisherian view is that, if ZIRP continues, it is very unlikely that we will see an increase in inflation—much more likely is the outcome in which the Fed continues to undershoot its 2 percent inflation target.15 This would be detrimental because predictable inflation is important for economic performance, as is the credibility of the Fed in delivering predictable inflation.

Even though the Fisher effect determines the effect of nominal interest rates on inflation in the long run, what if an increase in the nominal interest rate, under liftoff, causes inflation to fall even further below the 2 percent inflation target in the short run? Some recent research suggests that, even in conventional, mainstream New Keynesian macroeconomic models, this does not happen. Work by economist John Cochrane shows that a permanent increase in the nominal interest rate should lead to an increase in the inflation rate even in the short run.16 The effect is less than one-for-one initially and rises to one-for-one in the long run. Thus, Neo-Fisherism does not pertain to some peculiar set of macroeconomic models. In fact, conventional and widely used macroeconomic models have Neo-Fisherian properties.


After a long period of unconventional monetary policy, the Fed has embarked on a period of policy normalization, under which the fed funds rate target will ultimately return to normal levels, with the Fed’s balance sheet shrinking in size. Support for the Fed’s policy comes from both New Keynesian and Neo-Fisherian policy frameworks. Under the former framework, normalization is justified in that it forestalls excessive future inflation. Under the latter framework, normalization forestalls insufficient future inflation. In any case, the Fed’s announced plan is that normalization will continue for a considerable time, at a gradual pace, and in a manner that responds to macroeconomic events as they unfold.

Research assistance was provided by Jonas Crews, a research analyst at the Federal Reserve Bank of St. Louis.

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Neo-Fisherism: an economic doctrine that recognizes the Fisher effect—the positive effect of the nominal interest rate on inflation in the long run. Under Neo-Fisherian monetary policy, the central bank increases interest rates to increase inflation. [ back to text ]


  1. See Woodford’s 2003 work. [ back to text ]
  2. See Clarida, GalÍ and Gertler for an example of a New Keynesian model. Also, the NK Phillips curve is actually a relationship between an “output gap” and the rate of inflation, but for our purposes we will take the unemployment rate as a measure of the output gap. [ back to text ]
  3. See Taylor. [ back to text ]
  4. See Bullard. [ back to text ]
  5. See Cochrane. [ back to text ]

*Photo: © Getty Images / Bettmann / Contributor
**Photo: Library of Congress