Benefits of Comparing Policy with Reference Rules

In a recent VOX article, Henrike Michaelis and Volker Wieland write favorably about the approach taken by Fed Chair Janet Yellen in a recent speech where she compares recent Fed policy actions with several monetary policy rules—including the Taylor rule—much as would be required by recent legislation in the U.S. Congress. They argue that these kinds of “comparisons of Fed policy to simple reference rules show how such legislation would serve to bolster the Federal Reserve’s independence…. By referring to such legislation and appropriate reference rules, the Fed would be able to better stand up to … [political] pressure and more effectively communicate its reasons to the public.”  The article also refers to this statement by economists supporting the legislation.

As an illustration of the kind of constructive criticism that would likely be the healthy outcome of such comparisons, Michaelis and Wieland also take issue with one aspect of the Fed Chair’s comparison. They show that the comparison is incomplete, and thereby potentially misleading, because it uses only part of recent research by Holston, Laubach, and Williams (HLW).  The comparison applies the shift in the equilibrium interest rate r* from HLW, but not the associated shift in potential GDP that is an integral part of that study.  Janet Yellen shows that if you insert the HLW r* estimates into a Taylor rule, you get a lower policy interest rate than if you assume a 2 percent real rate as in the original version of that rule. However, Michaelis and Wieland show that plugging in the associated real output gap estimated with the HLW methodology, along with the HLW r*, moves the implied rate in the opposite direction.

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