Memphis, Tenn. – Federal Reserve Bank of St. Louis President James Bullard gave remarks titled “Modernizing Monetary Policy Rules” to the Economic Club of Memphis on Thursday. He suggested adjustments to monetary policy rules to account for important macroeconomic developments in recent decades.
In his talk, Bullard pointed out that “monetary policy rules have proven to be very useful in laying out benchmarks for monetary policy actions, both in academic papers and in practical policymaking.” One popular rule has been the 1999 version of the Taylor rule, referred to here as Taylor (1999), which was constructed based on U.S. data from the 1980s and 1990s.1
“Since that time, three important macroeconomic developments have altered key elements of policy rule construction,” he said. These developments are lower short-term real interest rates, the disappearing Phillips curve and better measures of inflation expectations.
“Incorporating these developments yields a modernized policy rule that suggests the current level of the policy rate is about right over the forecast horizon,” Bullard said.
Lower Short-Term Real Interest Rates
The first adjustment in a modernized version of the Taylor (1999) rule is to account for the trend in short-term real interest rates, which has been decidedly lower over the last three decades, he explained.
“The Fed can influence short-maturity real interest rates through monetary policy,” Bullard said. “However, the Fed cannot control longer-term trends in real interest rates, which are affected by relatively slow-moving macroeconomic factors like demographics, productivity trends and the global demand for safe assets.”
To obtain a trend value of the short-term real interest rate, he calculated the trend in a one-year ex-post safe real rate of return. He noted the current trend value of the short-term real interest rate is about zero. Therefore, he used zero as the value of “r-star” in the modernized policy rule.
The Disappearing Phillips Curve
The second adjustment is to account for the disappearing Phillips curve, which describes the feedback from the real economy to inflation. “In the 1970s and 1980s, this feedback was relatively strong and formed the basis for the part of the monetary policy rule labeled as the output gap,” Bullard said. “However, this feedback has attenuated markedly since that time, to the point where arguably there is very little feedback at all.”
Bullard noted that the degree of attenuation has been approximately a factor of 10 in the U.S. That is, an unemployment gap that would have generated 100 basis points of inflation in the past would today generate only about 10 basis points of inflation, he explained. To capture this in a modernized monetary policy rule, the coefficient adjusting for this effect can be reduced by a factor of 10, he said.
Better Measures of Inflation Expectations
The third adjustment would be to change the inflation gap term to measure the distance between the market-based expectations of inflation over the next five years and the inflation target, Bullard noted.
“In the 1980s and 1990s, there was no market for Treasury inflation protected securities (TIPS), and consequently there were no reliable real-time estimates of inflation expectations,” he said. “However, we now have about two decades’ worth of data on inflation compensation coming from these markets, and these data provide an important guidepost for monetary policymakers.”
One advantage of using inflation expectations in a modernized policy rule is that it allows for a forward-looking element in the rule, Bullard noted. “Forward-looking financial market participants are incorporating all available information—including existing theories, market developments and other policy developments—in forming their expectations of future inflation,” he said.
He added the current reading on market-based inflation expectations suggests that financial markets do not expect the Fed to attain its stated inflation target over the next five years on a personal consumption expenditures (PCE) inflation basis.
A Modernized Monetary Policy Rule
Bullard then examined the recommended policy rate path implied by the modernized monetary policy rule, which accounts for the three adjustments: using a lower value for the short-term real interest rate, reducing the feedback parameter from the real economy to inflation by a factor of 10 and replacing the inflation gap with an inflation expectations gap. He also compared this path with the median in the Federal Open Market Committee’s (FOMC) Summary of Economic Projections (SEP) and the policy rate path implied by the unmodernized Taylor (1999) rule.
He said that “the modernized version of the Taylor (1999) rule recommends a relatively subdued policy rate path over the forecast horizon—similar to the St. Louis Fed’s recommended path in the SEP.” The unmodernized Taylor (1999) rule calls for rapid increases in the policy rate, he noted, but this rule does not take into account the three important macroeconomic developments since the 1980s.
The median path for the policy rate in the FOMC’s September 2018 SEP arguably takes on board some of the modernization, Bullard said. Thus, the projected policy rate path is between the modernized and unmodernized versions of the Taylor (1999) rule.
1 The rule described here as the “Taylor (1999)” rule is slightly different from the one in Taylor (1999). Here, the current level of the interest rate also depends on the previous period’s value (smoothing).