Monetary Policy in practice

Taylor Rule: a simple equation (Rule of Thumb) that is intended to describe the interest rate decisions of the Federal Reserve’s FOMC. John Taylor argued that his rule should prescribe as well as describe – the rule should be a benchmark for monetary policy. Regardless of opinion, the rule described FOMC behavior quite well.

i= r* + pi + 0.5 (pi-pi*) + 0.5 (output gap).

Where:

i = nominal fed funds rate
r* = real federal funds rate
pi = rate of inflation
p* = target inflation rate

Taylor Rule predicts that the FOMC will raise the Federal Funds rate (tighten monetary policy by 0.5 % points:

• For each % point that inflation rises relative to the FED’s target, assumed to be 2%
• For each percentage point that output rises relative to its potential.
• When inflation is at target and output gap is zero, FOMC will set the real federal funds rate at 2% and nominal federal funds rate at 4% (historical average.

“As a policymaker I often referred to various policy rules, including variants of the Taylor rule. However, it seemed to me self-evident that such rules could not incorporate all the relevant considerations for making policy in a complex, dynamic economy.” – Ben Bernanke (FED Chairmen 2006-2014)

Application:

Why would John Taylor be critical of the FOMC in creating the Housing Bubble and handling the recovery?

• The figure shows the actual federal funds rate falling below the Taylor rule prescription both in 2003-2005 and since about 2011. If using the rule, monetary policy was at least somewhat “too easy”.

Using the formula and figure 1, why might the Taylor rule be not in line with the actual Federal funds rate?

• The FOMC targets overall PCE inflation, but has typically viewed core PCE inflation (which excludes volatile food and energy prices) as a better measure of the medium-term inflation trend and thus as a better predictor of future inflation.
• Janet Yellen has suggested that the FOMC's "balanced approach" in responding to inflation and unemployment is more consistent with a coefficient on the output gap of 1.0, rather than 0.5.

US Monetary Policy since the early 1990s is pretty well described by a modified Taylor rule. Does that mean that the FED should dispense with its elaborate deliberations and simply follow that rule in the future? General consensus says no. Taylor rule makes assumptions that might not be held constant.

• Policymakers know and agree on size of the output gap.
• Equilibrium federal funds rate is 2% in real terms and 4 in nominal terms.
• Taylor rule provides no guidance about what to do when the predicted rate is negative.
• No agreement on what the Taylor rule weights on inflation and the output gap should be.

Inflation Targeting: This involves the public announcement of medium-term numerical targets for inflation with an institutional commitment by the monetary authority to achieve these targets. Central Banks announce the inflation rate that they want to achieve and set up policy to achieve it. Bernanke was a big fan and started under his control.

• Early 1990s, New Zealand first to use this communicative policy. (1-3% range). Europe followed and currently Britain uses 2% target.
• The Fed pursued an unofficial inflation target over a long period, only making its policy official in January of 2012, when it announced that it thought a policy which targets a 2% rate of inflation "is most consistent over the longer run with the Federal Reserve's statutory mandate"
• Inflation target is forward thinking and Taylor Rule is backward looking.

Benefits of Targeting – Transparency and accountability

• Reduced inflation volatility
• Reducing inflationary impact of shocks
• Increased anchoring of inflation expectations

Costs of Targeting – implemented as a strict policy rule

• Restricted ability to respond to financial crisis or unforeseen events
• Potentially poor outcomes in employment, exchange rate and other macroeconomic variables
• Potential instability in the event of large supply side shocks
• Lack of support from the public

Measures, Values and Time Horizon

• Personal Consumption Expenditure – Core
• Rule based approach (Implicit 1.5 to 3%), Discretionary Approach (Explicit 2%)
• Bernanke mentions that the time horizon should fall under a 1 to 4 year range.

Other Targets

• Real GDP Target – neutralize the effects of aggregate supply shocks by changing aggregate demand.
• Increase AS, Decrease AD deflation, vice versa
• Stabilize real GDP, destabilize price level
• Price Level Target – adjust AD to stabilize prices, but destabilize real GDP
• Increase AS, Increase AD, vice versa

Unconventional Monetary Policy

• Problem during a recession is not that there is too little money, but little spending:
• Household cut back on their spending because of pessimism
• Businesses cut back because of lowered estimates of future profitability
• Major trading partners maybe suffering from recessions
• Purpose of monetary policy is to adjust interest rates, not give them money (illusion of increased money – increased reserves). Cutting rates is fine to increase growth in ordinary times. Lower rates induce customers to spend rather than save.
• Zero Lower Bound – zero interest rates as a boundary beyond which savers are not interested in putting money into banks as what they receive in return is less than what they deposited. If nominal interest rates were negative, people would not want to put their money into banks because doing so would mean that their balances would shrink over time (rather than grow with positive rates). (1930s and 2009)
• Liquidity Trap – a situation in which conventional monetary policy to fight a slump – cutting rates – cannot be used because nominal interest rates are up against a zero lower bound. (Pushing on a string!)

Money Market Model
/ ISLM Model

• Zero Interest Rate Policy (ZIRP)
• Quantitative Easing – central banks create money by buying securities, such as government bonds, from banks, with electronic cash that did not exist before. Like lowering interest rates, QE is supposed to stimulate the economy by encouraging banks to make more loans. This should increase reserves without impacting short term rates. The idea is that banks take the new money and buy assets to replace the ones they have sold to the central bank. That raises stock prices and lowers interest rates, which in turn boosts investment. Today, interest rates on everything from government bonds to mortgages to corporate debt are probably lower than they would have been without QE. If QE convinces markets that the central bank is serious about fighting deflation or high unemployment, then it can also boost economic activity by raising confidence.
• March 2009 – QE purchase of \$1.75 trillion (Treasuries and MBS of Freddie, Fannie)
• November 2010 – QE2 purchase \$600 billion of treasuries at rate of \$75 billion per month over next 8 months.
• Forward Guidance – pre-announcing size (How Much?) and duration (How Long?) Lending would not be delayed because of potential reserve policy.
• September 2011 – Operation Twist purchases long term government bonds while simultaneously selling an equivalent dollar amount of short term bonds.
• Spur investment and consumption (Real and/or Psychological)
• Increase Bonds prices and decrease yields on Long Term securities
• Short term bond sales was not enough to impact short term rates.
• Twist #1: 400 billion over nine months
• Twist #2: 267 billion over six months (June 2012)

• September 2012 – QE3 purchased 85 billion per month of bonds (40 billion in MBS and continued operation twist) with no specific end date. FED Funds rate would remain “exceptionally low” as long as the unemployment rate stayed above 6.5% and inflation rate was below 2% (Explicit Targets).
• December 2012 – Announced completion of "Operation Twist", expanded QE3 to \$85 Billion per month. (\$40 billion of MBS and \$45 billion of treasuries)
• December 2013 – Announced "tapering" of QE3. Note: QE3 tapered \$10-15 billion per month at each meeting of 2014.
• October 2014 - ended its historic easing program, ceasing the final \$15 billion of monthly bond purchases. Though it ended the program, the Federal Open Market Committee kept the "considerable period of time" language that investors had considered crucial in the central bank's map for when it would raise interest rates.
• December 2015 – (“Liftoff”) The Federal Reserve raises its benchmark interest rate, currently close to zero, by a quarter of a percentage-point. That would be its first increase since June 2006. (important to reach a normalized economy.)

Monetary Policy – Final Verdict

• Faster than Fiscal Policy and more flexible (accommodative)
• Isolation from political pressure
• Lags still exist: (Figure 26-9)
• Recognition Lag – What is the economic situation?
• Operation Lag – 3 to 6 months for policy to have full impact
• Reflationist – an individual thinks pumping a lot more money into the economy could jump start inflation in the next few years.

Monetary Policy in practice

Taylor Rule:

i= r* + pi + 0.5 (pi-pi*) + 0.5 (output gap).

Where:

i = nominal fed funds rate
r* = real federal funds rate
pi = rate of inflation
p* = target inflation rate

Taylor Rule predicts that the FOMC will raise the Federal Funds rate (tighten monetary policy by 0.5 % points:

“As a policymaker I often referred to various policy rules, including variants of the Taylor rule. However, it seemed to me self-evident that such rules could not incorporate all the relevant considerations for making policy in a complex, dynamic economy.” – Ben Bernanke (FED Chairmen 2006-2014)

Application:

Why would John Taylor be critical of the FOMC in creating the Housing Bubble and handling the recovery?

Using the formula and figure 1, why might the Taylor rule be not in line with the actual Federal funds rate?

US Monetary Policy since the early 1990s is pretty well described by a modified Taylor rule. Does that mean that the FED should dispense with its elaborate deliberations and simply follow that rule in the future? General consensus says no. Taylor rule makes assumptions that might not be held constant.

Inflation Targeting: This involves the public announcement of medium-term numerical targets for inflation with an institutional commitment by the monetary authority to achieve these targets. Central Banks announce the inflation rate that they want to achieve and set up policy to achieve it. Bernanke was a big fan and started under his control.

Benefits of Targeting – Transparency and accountability

Costs of Targeting – implemented as a strict policy rule

Measures, Values and Time Horizon

Unconventional Monetary Policy

• Problem during a recession is not that there is too little money, but little spending:
• Purpose of monetary policy is to adjust interest rates, not give them money (illusion of increased money – increased reserves). Cutting rates is fine to increase growth in ordinary times. Lower rates induce customers to spend rather than save.
• Zero Lower Bound – zero interest rates as a boundary beyond which savers are not interested in putting money into banks as what they receive in return is less than what they deposited. If nominal interest rates were negative, people would not want to put their money into banks because doing so would mean that their balances would shrink over time (rather than grow with positive rates).
• Liquidity Trap – a situation in which conventional monetary policy to fight a slump – cutting rates – cannot be used because nominal interest rates are up against a zero lower bound.

Money Market Model / ISLM Model
• Zero Interest Rate Policy (ZIRP)
• Quantitative Easing – central banks create money by buying securities, such as government bonds, from banks, with electronic cash that did not exist before. Like lowering interest rates, QE is supposed to stimulate the economy by encouraging banks to make more loans. This should increase reserves without impacting short term rates. The idea is that banks take the new money and buy assets to replace the ones they have sold to the central bank. That raises stock prices and lowers interest rates, which in turn boosts investment. Today, interest rates on everything from government bonds to mortgages to corporate debt are probably lower than they would have been without QE. If QE convinces markets that the central bank is serious about fighting deflation or high unemployment, then it can also boost economic activity by raising confidence.
• March 2009 – QE purchase of \$1.75 trillion (Treasuries and MBS of Freddie, Fannie)
• November 2010 – QE2 purchase \$600 billion of treasuries at rate of \$75 billion per month over next 8 months.
• Forward Guidance – pre-announcing size (How Much?) and duration (How Long?) Lending would not be delayed because of potential reserve policy.
• September 2011 – Operation Twist purchases long term government bonds while simultaneously selling an equivalent dollar amount of short term bonds.
• Spur investment and consumption (Real and/or Psychological)
• Increase Bonds prices and decrease yields on Long Term securities
• Short term bond sales was not enough to impact short term rates.
• Twist #1: 400 billion over nine months
• Twist #2: 267 billion over six months (June 2012)

• September 2012 – QE3 purchased 85 billion per month of bonds (40 billion in MBS and continued operation twist) with no specific end date. FED Funds rate would remain “exceptionally low” as long as the unemployment rate stayed above 6.5% and inflation rate was below 2% (Explicit Targets).
• December 2012 – Announced completion of "Operation Twist", expanded QE3 to \$85 Billion per month. (\$40 billion of MBS and \$45 billion of treasuries)
• December 2013 – Announced "tapering" of QE3. Note: QE3 tapered \$10-15 billion per month at each meeting of 2014.
• October 2014 - ended its historic easing program, ceasing the final \$15 billion of monthly bond purchases. Though it ended the program, the Federal Open Market Committee kept the "considerable period of time" language that investors had considered crucial in the central bank's map for when it would raise interest rates.
• December 2015 – (“Liftoff”) The Federal Reserve raises its benchmark interest rate, currently close to zero, by a quarter of a percentage-point. That would be its first increase since June 2006.

Monetary Policy – Final Verdict