Guest Contribution: How Janet Yellen Might Have Responded to the Policy Rules Legislation

Today, we’re fortunate to have Alex Nikolsko-Rzhevskyy, Assistant Professor of Economics at Lehigh University, David Papell and Ruxandra Prodan, respectively Professor and Clinical Assistant Professor of Economics at the University of Houston, as Guest Contributors


In a contentious hearing before the House Financial Services Committee, Federal Reserve Chair Janet Yellen reacted extremely negatively to the proposed “Federal Reserve Accountability and Transparency Act of 2014”, introduced into Congress on July 7, which would require the Fed to adopt a policy rule. As reported in The New York Times and the Wall Street Journal on July 16, she called the proposal a “grave mistake” which would “essentially undermine central bank independence.” In the next day’s Wall Street Journal, Alan Blinder wrote that “In a town like Washington, the message to the Fed would be clear: Depart from the original Taylor rule at your peril.”

Did the proposed legislation deserve such a strong response? The act specifies two rules. The “Directive Policy Rule” would be chosen by the Fed, and would describe how the federal funds rate would respond to a change in the intermediate policy inputs. If the Fed deviated from its rule, the Chair of the Fed would be required to testify before the appropriate congressional committees as to why it is not in compliance. In addition, the report must include a statement as to whether the Directive Policy Rule substantially conforms to the “Reference Policy Rule,” with an explanation or justification if it does not. The Reference Policy Rule is the Taylor rule.

In a recent Econbrowser post, we discussed the justification for using the Taylor rule as the Reference Policy Rule. Here, we consider how Janet Yellen might have responded more positively to the proposed legislation. According to the Taylor rule, the Fed should set the short-term interest rate as follows:

r = π + 0.5 (π – π*) + 0.5 y + R,

where r is the federal funds rate, π is the inflation rate over the previous four quarters, y is the output gap, the percentage deviation of GDP from potential GDP, π* is the inflation target of 2.0 percent, and R is the equilibrium real interest rate, also 2.0 percent. Collecting terms,

r = 1.0 + 1.5 π + 0.5 y.

In a June 2012 speech, Yellen expressed a preference for a variant of the Taylor rule that is twice as responsive to economic slack, which she called the “balanced-approach” rule,

r = 1.0 + 1.5 π + 1.0 y.

With GDP forecasted to remain below potential, the balanced-approach rule prescribed raising the federal funds rate above the zero lower bound later than the Taylor rule prescription. She also discussed an optimal control path for the federal funds rate using the Fed’s FRB/US economic model, which prescribed an even later lift-off date.

Yellen’s speech provides a template for how the Fed might respond to the proposed legislation. There is nothing in the legislation that requires the Fed to adopt the Taylor rule. Suppose the Fed had chosen the balanced approach rule as the Directive Policy Rule. Her speech clearly showed how the Directive Policy (balanced approach) Rule differed from the Reference Policy (Taylor) Rule and, using the FRB/US model, provided a justification for using the Fed’s rule.

Suppose that the proposed legislation was current law. How might the Fed respond? For the purpose of argument, assume that the Fed chooses the balanced approach rule as the Directive Policy Rule. Using the economic projections from the June 2014 FOMC meeting for inflation and real GDP growth, the Q1 final release real GDP numbers from the Bureau of Economic Analysis, and the potential GDP projections from the Congressional Budget Office, the prescribed federal funds rate using the Reference Policy (Taylor) Rule is 1.63 percent at the end of 2014 and 2.35 percent at the end of 2015. With the assumed Directive Policy (balanced approach) Rule, it is -0.15 percent at the end of 2014 and 1.14 percent at the end of 2015.

The prescribed federal funds rates with the balanced approach rule for the end of 2014 and 2015 are almost exactly the same as the target federal funds rates reported by the FOMC participants in the June 2014 economic projections. For the end of 2014, 15 Federal Reserve Board Members and Bank Presidents reported a target federal funds rate of 0.25 percent, with one participant at 1.0 percent. Given that the target federal funds rate is constrained by the zero lower bound, this is very close to prescription of the balanced approach rule. For the end of 2015, three participants reported a target of 1.0 percent and three more reported a target of 1.25 percent, with five participants below 1.0 percent and five above 1.25 percent. The median of 1.125 percent is amazingly close to the 1.14 percent rate prescribed by the balanced approach rule. The target rates for both the end of 2014 and 2015 are, not surprisingly, considerably below the rates prescribed by the Taylor rule.

Current Fed policy can be very well described by the balanced approach rule. If it was adopted as the Directive Policy Rule, there would be no need for the Chair to testify before Congress because, at least at this time, there are no deviations. If the Fed were to deviate in the future, it would improve transparency for the Chair to explain why. While the Directive Policy (balanced approach) Rule would not be the same as the Reference Policy (Taylor) Rule, there is nothing in the proposed legislation that requires them to be the same, and Janet Yellen has certainly been both willing and capable of defending her preference. We do not see how central bank independence would be undermined if the process was formalized.


This post written by Alex Nikolsko-Rzhevskyy, David Papell and Ruxandra Prodan.

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7 thoughts on “Guest Contribution: How Janet Yellen Might Have Responded to the Policy Rules Legislation

  1. Lord

    They would also have to specify an error bound since none of these are known in advance or even current, nor with perfect accuracy and they would not want to attempt over control on the basis of lagging data.

  2. Patrick R. Sullivan

    What is it with this interest rate fetish? That’s what got the Fed to ignore the Great Depression, and the Bank of Japan to keep that country in recession for two decades.

    Repeat after Milton Friedman; ‘Interest rates are not a reliable indicator of monetary policy.’

    1. 2slugbaits

      Repeat after Milton Friedman; ‘Interest rates are not a reliable indicator of monetary policy.’

      And M2 is???

      1. Patrick R. Sullivan

        Probably more reliable than the Fed Funds rate, yes. Noting the temporary exception in the 1980s (as Alan Greenspan did in his last book) .

        But that’s beside the point, since nominal GDP growth probably is better than either. Certainly would have been in the USA in the 1930s and 1990s Japan.

    1. Patrick R. Sullivan

      If you’re asking if monetary policy could be conducted by open market operations (i.e., buying and selling bonds), yes, Friedman recognized that was possible.

    2. Get Rid of the Fed

      I have had one economist tell me that buying and selling assets is the definition of monetary policy.

      What is your definition of monetary policy?

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