Carmel, Ind. – Federal Reserve Bank of St. Louis President James Bullard gave remarks titled “More on Modern Monetary Policy Rules” to the Indiana Bankers Association on Friday. He further elaborated on some key directions the Fed could take to update monetary policy rules.
In his talk, Bullard pointed out that “monetary policy rules have proven to be very useful in laying out benchmarks for monetary policy actions.” 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. He noted that the Fed can influence short-term real interest rates through monetary policy but cannot control trends in these rates.
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 safe real interest rate is about zero in the U.S., and is even lower when measured on a global basis.
Therefore, he used zero as the value of “r-star” in the modernized policy rule, and assumed it would not change appreciably over the forecast horizon. “I think this is prudent given the especially low value of the global safe real rate,” Bullard said.
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. As a first pass to capture this in a modernized monetary policy rule, the coefficient on the output gap can be reduced by a factor of 10, he said.
Better Measures of Inflation Expectations
The real-time measurement of inflation expectations has improved markedly in the U.S., Bullard noted. Therefore, the third adjustment to the policy rule 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.
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.
Bullard 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. When incorporating an expected inflation gap in the modernized version of the monetary policy rule, he also assumed that expected inflation returns to target over the forecast horizon, he pointed out.
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, accounting for the reduction of the feedback from the real economy to inflation 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 and 1990s.
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).
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