The market-perceived monetary policy rule

Stanford Professor John Taylor has suggested that monetary policy could be summarized in terms of a simple rule, lowering interest rates when output is too low and raising them when inflation is too high. A number of academic papers have investigated this rule from the perspective of describing what the Federal Reserve has historically done. In a new paper co-authored with Federal Reserve economist Seth Pruitt and Office of Immigration Statistics economist Scott Borger, I take a look at what monetary policy rule the market perceived the Fed to be following over different historical periods.

Our basic idea is that, back in the days before we ran into the zero lower bound on interest rates, if there was a major surprise in a macroeconomic news release, you would see a big change in fed funds futures prices. For example, when the BLS announced on March 8, 1996 that nonfarm payrolls increased by 705,000 workers in February (wouldn’t we love to see another report like that one about now!), the interest rate associated with the August fed funds futures contract jumped from 5.01% to 5.25%. That response reflected a market belief that the development would cause the Fed to choose a higher interest rate than it otherwise would have.

We then built simple forecasting models for how news like this would alter a rational forecast of future inflation and output growth and ask, if market participants were revising their expectations in a way consistent with those forecasting relations, and if they thought that the Fed would respond to those future fundamentals according to a Taylor Rule, what parameters for the Taylor Rule are most consistent with the observed response of fed funds futures prices?

Our estimates are similar to those derived from more conventional econometrics, and suggest that, since 1994, the market believed that monetary policy was consistent with the Taylor Principle, raising the nominal interest rate more than 1-for-1 with an increase in inflation. Output targeting, particularly over the 2000-2007 period, appears to have been assigned secondary importance by the market.

One of the advantages of our approach is that we are also able to come up with estimates for the degree of inertia in perceived monetary policy. For example, while the August 1996 contract experienced a 24-basis-point jump on March 8, the May contract only moved 10 basis points. Since we can describe how the March 8 news should have altered a forecast for both May and August inflation, we can come up with direct measures for how long the market expected it would take the Fed to adjust interest rates fully in response to the news.

We document two important changes in the perceived policy rule over time. After 2000, the market believed that the Fed would eventually have a stronger response to inflation than it had prior to 2000, but also that the Fed would take longer to implement those changes, responding to news more sluggishly than it had before 2000.

We study the consequences of these changes using a simple new-Keynesian model. We find that the first change (a stronger long-run response to inflation) would be something that would have made output less variable, whereas the second change (a smaller immediate response) would have made output more variable. According to these simulations, increased Fed inertia undid some of the benefits it could have otherwise obtained with its anti-inflation policies.

Our conclusion is that the measured pace at which Greenspan increased interest rates over 2004-2005 may have been counterproductive, and that economic performance might have been improved if the Fed instead had raised interest rates more quickly to the higher warranted levels.

29 thoughts on “The market-perceived monetary policy rule

  1. ppcm
    The above analysis coupled with the reading of the actual structural imbalances may offer a post mortem confirmation of how ineffective Fed, Greenspan led and ECB have been when driving the monetary policies.
    Good to read that J Taylor is back on the front seat,but when are you going to call back the Marshallian K?

  2. Bob_in_MA

    Everyone seems to agree now that rates were kept low for too long and were raised too slowly. But I have to wonder, were economists warning about it at the time?
    So much of academic economics seems to be looking at the past and trying to determine what caused X, Y or Z to occur, e.g., Friedman & Schwartz on the Great Depression.
    Since each event involves so many myriad variables, the conclusion is obviously untestable, but if it seems to hold true for long enough, it may become orthodoxy. Greenspan, et al., were really following the playbook by avoiding deflation at all costs.
    For the last 30 years, the Fed has operated according to this plan. Meanwhile, household debt as a proportion to income, or GDP, doubled. But what if the real problem in 1929 was debt levels and the subsequent deleveraging, and not the actions of the Fed?

  3. paofpa

    Inflation: needs totally rewritten.
    Interest Rates: are reflecting the transfer of assets, not the production of assets.
    I know you have great ideas. But that,s for “A long time ago in a galaxy far, far away”
    Try steadying the Private Debt/GDP ratio; a normal banking concept.

  4. enrique

    I beg your pardon : Why its so easy to reach make clean and mainstream conclusions about the past while we all know that Chairman Bernanke was deeply involved in those decisions?
    Regarding the present : What are exactly the possible outcomes of the hysterical (not typo!)rates levels ? Arent we watching the trailer of the second chapter of this tremendous new bubble ? ( accompanied by a morally hazard implicit guarantee for “too big institutions”?)

  5. One Salient Oversight

    One of the most obvious examples of bad policy in recent years was the descent into negative interest rates. Between 2003 and 2006, the inflation rate was higher than the interest rate, which essentially punished anyone who kept money in the bank and rewarded anyone who invested in an industry with high returns… say, the housing market.
    One of the integral “harsh medicines” of the Washington Consensus imposed upon developing nations needing IMF/World Bank help was the commandment “thou shalt not have negative interest rates”. Had the Washington Consensus actually been followed by Federal Reserve people and politicians in Washington, the US would not be in the mess it is in.
    And this argument, of course, backs up the notion that interest rates were kept too low for too long.

  6. joebhed

    The worn-out idea of determining movements in the money-supply using these interest-related metrix will hopefully soon be history.
    Under the Chicago Plan for Monetary Reform – this is not yet an Obama plan – the changes required in the size of the money supply are not gambled away with interest rate futures; they are identified, targeted, budgeted and met.
    The debt-money-system of fractional reserve banking is insolvent.
    We cannot create enough new debt-money to make the payments on the debt-money already out there in its various forms of financially-engineered exotica.
    We need a nw money system, not improved interest-rate shenanigans.
    It’s OUR money system.
    The Money System Common.

  7. kharris

    One of the recurring themes in big-picture, survey-the-horizon economics is that forecasting is not a good idea. Given that, I would argue that criticizing economists for knowing there limitations and not making great claims for their ability to see the future is also not a good idea.
    This is not, of course, something that only economists suffer. I have been in too many rooms in which the guy running the meeting gets frustrated when specialists tell him what they know, rather than what he wants to know. Often, the pressure works. The specialists guess, but are unable to convey to the guy demanding answers that the guess is not as reliable as the normal run of their work. Pile a few guesses on top of other guesses, add in that some of the guesses are tilted to make the guy at the top happy (recognizing that “the guy at the top” may be the general public, share holders, etc), and you get asset bubbles, wars that shouldn’t have been fought, and innocent people being fried in the name of justice.
    Before calling on someone do something, you might want to look into what they are able to do well, and what they can’t be expected to do any better than the next guy.
    Oh, and when a whole bunch of people do make forecasts, it wouldn’t hurt to keep track of who has a good record. Many of the forecasts we hear are simply done because the job calls for it, with little attention paid to whether the forecasts are any good.

  8. DickF

    Menzie took issue with my friend Don Luskin (and in fairness so did I only for other reasons) when he called for higher FED interest rates. There were a number of economists calling for higher interest rates at the time. I believe that Greenspan was more driven by his legacy than his economics and was afraid high interest rates would contract the economy just as he was taking his final bows.
    Just for the record my take is that interest rates have very little impact on the economy and money supply one way or another. If you look at the Great Depression and at the Great Credit Crisis you will find that the actual crashes were caused by bad policy decisions not FED policy. All the FED does with its manipulations is make it harder for traders to balance the conditions of trades, but markets adapt in remarkable ways. The problems come when politicians see that the monetary manipulations are not working and they decide to force change through central planning policy moves precipitating a crash, such as the TARP fiasco.

  9. flow5

    The money supply and aggregate demand can never be managed by any attempt to control the cost of credit.
    It is mathematically impossible to miss economic forecasts. If you can’t forecast then you don’t understand economics period.

  10. flow5

    First, there is no ambiguity in forecasts: In contradistinction to Bernanke (and using his terminology), forecasts are mathematically “precise :
    (1) nominal GDP is measured by monetary flows (MVt);
    2) Income velocity is a contrived figure (fabricated); its the transactions velocity (bank debits, or demand deposit turnover) that matters; (all transactions cleared through demand deposits)
    (3) money is the measure of liquidity; &
    (4) the rates-of-change (rocs) used by the Fed are specious (always at an annualized rate; which never coincides with an economic lag). The Feds technical staff, et al., has learned their catechisms;
    Friedman became famous using only half the equation (the means-of-payment money supply), leaving his believers with the labor of Sisyphus.
    Contrary to economic theory, the lags for monetary flows (MVt), i.e. proxies for (1) real-GDP and the (2) deflator are exactly the same. They never vary.
    Rocs in (MVt) are always measured with the same length of time as the specific economic lag (as its influence approaches its maximum impact; as demonstrated by the clustering on a scatter plot diagram).
    Not surprisingly, adjusted member commercial bank “gratis” legal reserves (their rocs) corroborate or mirror, both of the lags, for monetary flows (MVt) — their lengths are always identical — (as the weighted arithmetic average of reserve ratios remains constant)
    Because the lags for both monetary flows (MVt) & “gratis” legal reserves are synchronous. They are indistinguishable Consequently, economic forecast are mathematically infallable (which includes housing bubbles, commodity bubbles,,bubbles, etc.).
    This is the Holy Grail & it is inviolate & sacrosanct. And it is obvious to anyone that has examined the data.
    The BEA uses quarterly accounting periods for real GDP and deflator. The accounting periods for GDP should correspond to the economic lag, not quarterly.
    Monetary policy objectives should not be in terms of any particular rate or range of growth of any monetary aggregate. Rather, policy should be formulated in terms of desired rocs in monetary flows (MVt) relative to rocs in real GDP.
    Note: rocs in nominal GDP can serve as a proxy figure for rocs in all transactions. Rocs in real GDP have to be used, of course, as a policy standard.
    Because of monopoly elements, and other structural defects, which raise costs, and prices, unnecessarily, and inhibit downward price flexibility in our markets, it is probably advisable to follow a monetary policy which will permit the roc in monetary flows to exceed the roc in real GDP by c. 2 3 percentage points.
    In other words, some inflation is inevitable given our present market structure and the commitment of the federal government to hold unemployment rates at tolerable levels.
    Some people prefer the devil theory of inflation: Its all Peak Oil’s fault” or Peak Debt’s fault”. This approach ignores the fact that the evidence of inflation, is represented by “actual” prices in the marketplace.
    The “administered” prices of the world’s oil producing countries would not be the “asked” prices were they not validated by (MVt), i.e., validated by the world’s Central Banks.

  11. DickF

    JDH wrote:
    For example, when the BLS announced on March 8, 1996 that nonfarm payrolls increased by 705,000 workers in February (wouldn’t we love to see another report like that one about now!), the interest rate associated with the August fed funds futures contract jumped from 5.01% to 5.25%. That response reflected a market belief that the development would cause the Fed to choose a higher interest rate than it otherwise would have.
    What is so amazing about this finding is that there is such a bias against growth that the FED will work against economic growth and good news. What news except for prosperity was there to suggest that interest rates should be raised? China is growing at 10% and the Chinese inflation rate is very close to that of the US because the currencies of the two countries are virtually pegged. So is it growth that causes inflation? It is absolutely insane. And we wonder why our economy is in trouble.
    Professor, I think perhaps one of your goals should be to determine how to change the views of investors that their success will cause the FED to look for ways to thwart them. No, better, how can we change the thinking of the FED not to punish success.

  12. David

    that the Fed follows the market when setting rates is highly correlated. All else is rationalization; working backward from the fact to conclude with an assumption of the cause.
    Why complicate this more? Must be some secondary need. Perhaps the fact that the maestro’s allow the free market, arms length, willing transaction between sellers and buyers of interest bearing notes to take place in the hallowed and secret halls of the Fed and to pronounce – like smoke from the Vatican – their ‘policy’ and the accompanying Fed speak: more smoke and mirrors.
    And this rate setting is the foundation of the so-called free market economy. I laugh out loud, and often.

  13. Cedric Regula

    My understanding of why Greenspan chose his “measured pace” policy was due to Greenspan’s understanding of the proper way to implement monetary policy, which he learned by trial and error as far as I can tell during the ’90s.
    In 1994 he raised rates very rapidly, which caused some unforeseen things in the derivatives market and the subsequent bankruptcy of Orange County, CA.
    It also had a lot to do with the 1994 Mexican currency crisis and I think even may have sown the seeds of the 1997 Asian currency crisis. The problem here is the dollar is the reserve currency and there is much international lending done in the dollar. In the latter ’90s we had real interest rates, which helps make for a strong dollar, tho we also had a strong economy, falling trade deficit, and financial inflows chasing the US stock bubble which helped. But the point is that foreign dollar denominated loans can cause debtors to default when the dollar strengthens or rates rise unexpectedly.
    This decade we got a dollar rally due to the safe haven effect, and in addition to EM equity investment being repatriated to the US, international banks again refused to roll over a lot of short term dollar lending in foreign markets. The Fed didn’t start this one with monetary policy, but it was a reminder of the large amount of dollar finance there is around the world.
    So I think the lesson that Greenspan came away with in the 90s is the right way to do it is ‘down fast”, “up slow”. He did “down fast” in response to the Asian currency crisis, and gave himself a big pat on the back for containing contagion.
    But he obviously screwed up domestic policy in 2001-2005 this way, because it was probably a key part of getting the housing bubble monster going.
    So as far as I can tell, there is no way to do Fed policy correctly if you also have a large international banking industry. Milton Friedman, who was right once and a while, said the Fed can manage domestic interest rate policy, or the external value of the currency, but not both at the same time. So if we ever get past the domestic lending solvency problem we have now, I think the Fed will ever be conflicted over domestic needs vs. solvency of international banks. And we have seen how the US taxpayer is on the hook if anything ever goes wrong with banks.

  14. DickF

    From the paper The Market-Perceived Monetary Policy Rule pp 22-23:
    To explore this issue empirically, we will be looking at the properties of the Congressional Budget Office’s series for quarterly potential real GDP growth, denoted y-q where q indexes quarters. As currently reported, y-q is an extremely smooth and highly predictable series.
    Professor, this sentence doesn’t make sense to me based on what follows.
    However, over time the CBO will make many revisions to its estimate of the value of y-q for a given historical quarter q. For example, on April 17, 1996, CBO estimated the growth rate of potential GDP for q = 1995:Q4 to be 1.98% (at an annual rate), whereas by January 8, 2009, they had revised the estimate for y-1995:Q4 up to 2.76%.
    How can you even get close when it takes 13 years to get a number and then it is 37.8% higher than the original number. And this is the kind of econometrics that is driving FED policy decisions that impact the economy of the whole world?
    Orphanides (2001) and Orphanides and van Norden (2002) demonstrated that such revisions can pose a big problem for traditional Taylor Rule estimates.
    Big problem? Oh, really? What was your first hint? I think Orphanides is a Master of understatement. Imagine a 38.7% error compounded over 13 years. Is it any wonder our economy is screwed up. And that is assuming that the Taylor Rule works without compounding the error.

  15. Bob_in_MA

    The point I was trying to make is that if the lessons and rules of economic policy are always based on interpretations of the past, and can never be fairly tested, they may not be of much use in the real world.
    Right now, many economists are patting Bernanke, et al., on the back and saying, they followed the lessons Friedman and Schwartz gave us, and avoided a depression.
    But what is the crux of the problem is the level of debt and solvency, and not interest rates, the money supply and velocity?
    Then the solution will involve decreasing debt. But much of the Fed’s actions have been to keep debt creation available. And the policies most responsible the current apparent recovery are the cash-4-clunkers program, where the vast majority of buyers are buying on credit without the need to put any money down, and the rise in home sales, many to first-time buyers using FHA loans requiring just 3.5% down, before the $8,000 credit is added in.
    Our economic policy consists of “solutions” that INCREASE debt levels relative to GDP!
    Could it be that we have just kicked the can into next year? And might it not turn out that we have made the problem worse, via the policies we are now lauding?

  16. JDH

    DickF: Perhaps our phrase “as currently reported” was confusing. By this phrase we meant the vintage-2009 series. Your 38% change refers to the revisions across different vintages, which is the problem that our methodology specifically addresses.

    All: I did not mean to give the impression that I endorse the view that Greenspan’s interest rate policy was the sole cause of our current problems. Instead my view is that regulatory lapses were the single most important factor.

  17. Cedric Regula

    Like all drug addicts, it’s change that makes us ill!
    I just saw a long term graph of total debt; consumer, corporate and government added together, and it does indeed still slope upward despite the much reported consumer and banking “deleveraging”.
    It is government debt that is taking up the slack from the private sector, although new corporate bond issuance has been strong as well.
    And that is what Ben said he is trying to do with all his unique programs…be the lender of last resort.
    So they can kick the can down the road for a while yet…USG debt/GDP is still lower than Japan, Europe, and Britain lately. Tho the IMF recently said Japan will be technically insolvent by 2004, so this is not something to brag about. Then QE makes borrowing unnecessary, so we may have found the solution to economic Nirvana. Keep your fingers crossed and just believe!
    JDH: It is rather silly to think the Fed can run the global economy with an interest rate. Effective global regulation is the only hope. World leaders thought so too a year ago, and I hope the concept doesn’t fall by the wayside. As a taxpayer, I don’t want to have to someday pay for bad loans to Libya or wherever else our Big 10 go. With banks having to mark to market credit risk, geographical risk, currency risk, and interest rate risk, I can see more big bills in our future already.

  18. Cedric Regula

    “Tho the IMF recently said Japan will be technically insolvent by 2004,..”
    That s/b 2014!

  19. dismal

    I tend to agree with Mandelbrot: “…so limited is our knowledge that we resort, not to science, but to shamans. We place control of the world’s largest economy in the hands of a few elderly men, the central bankers. We do not understand what they do or how, but we have blind faith that they can somehow induce the economic spirits to bring us financial sunshine and rain…”(p. 255, The (Mis)behavior of Markets, 2004)- dismal science indeed, “Finance must abandon its bad habits, and adopt a scietific method”. Very informative and engaging book that makes no pretence to know it all.

  20. DickF

    From your post you seem to be a thoughtful and reasonable man. Consider what you wrote:
    JDH: It is rather silly to think the Fed can run the global economy with an interest rate. Effective global regulation is the only hope.
    If the FED cannot run the global economy what makes you think that another global regulatory agency will do any better? We exhibit dangerous hubris when we ignore the wisdom of Frederik Hayek that only free markets can have the knowledge sufficient to “run” an economy. We are suffering today under the foolishness of pompous men who assume themselves to be omnipotent, omnicient, and, in the case of the free market, even assuming omnipresence, or at least assuming knowledge of every location in the world.
    It is hubris that makes King Canute look down right democratic.

  21. ppcm

    Cedric Hello
    Interesting to read two comments one lauding the Mandelbrot set that is fractal forms and complex plane and the other a uniform set led by one preset the Fed.
    The uniformity of monetary policies and somehow a single currency in Europe has attempted to deny the complexity of a complex plane (fiscal policy,BOP…)
    I would be enclined to wait for further time to make a judgement on how the boundaries and fractal points are going to react under stress before thinking of a uniform set,and monetary policies.The case is open for studies and not for conclusion if the past is a reference.

  22. DickF

    I have mentioned it before. Many are able to define the Laffer curve, but few actually understand its implications. The Laffer curve becomes more and more important as taxes increase.
    It is not rocket science to understand that high taxes drive traders out of the money economy resulting in a fall in government revenue. The economic philosophy of our current government, the new-Keynesian model that blends the Keynesian model of bond illusion with the monetarist money illusion. This means that economic solutions are based on increasing taxes or increasing deficits when revenues fall (the Keynesian bond illusion) or adjusting the money supply (the monetarist money illusions). Today many blend the two believing we can overcome deficit spending through monetarist injections of liquidity creating inflation allowing us to pay off our deficits with depreciated money (the money illusion).
    This is where an understanding of the Laffer curve is vital. When taxes are high traders will reduce incomes reported in the money economy through barter or in our modern economy munis, tax shelters, or the black market. Simply inflating the currency will not reverse the Laffer curve effect because inflation does not change the actual terms of trade, the actual interchange of goods and services.
    While the monetarist cure of inflating away past debts may be true, with such huge current government expenditures as we have today (Obama economists project $9 trillion deficits, $30,000 for every man, woman, and child in the US) and with the resulting decrease in tax revenue because of the Laffer effect, we will find that the current position of government revenue will continue to deteriorate. We cannot inflation away current deficits so our government will face a huge strain of both inflation and reducing revenue. The supporters of totalitarian force will be greatly strengthened and may lead to Nixonian wage and price controls, or draconian tax collection techniques all fueling the black market.

  23. Steve Kopits

    OT: This month’s Atlantic has an excellent article on the role of Paulson and Bernanke in the BoA Merrill acquisition. Well worth reading. Actually, the entire issue is first rate.

  24. MikeR

    On controlling the economy with an interest rate…
    back in my day, the Fed had only three tools, the discount rate, the reserve requirement, and open market operations.
    Kudos to Bernake for expanding the open market operations program.
    However, interest rates at 6% vs. 4% vs. 1% don’t cause recessions or bank runs. What the fed really is trying to control is risk aversion.
    Perhaps xanax in the drinking water would do the trick.

  25. Cedric Regula

    Austrian Economics may sound attractive at first blush, but it is like wishing for a Libertarian legal system. We just don’t get there… one because it is too far removed from what we have in the real world, second because there are crooks in the world and most people don’t like living with crooks.
    My view of the financial system is that it has steadily evolved into an industry of legalized white collar crime, and it has got to the point where we cannot just ignore it. Rule of Law is necessary to make it work.
    We don’t have the luxury of saying “regulation doesn’t work”, so lets not do it. We have to meet the challenge of making it work. If we don’t they will continue to “private gains and socialize losses.”. Personally, I can’t afford that, and secondly, it makes me mad.
    And coming up with a less fallible system is not as impossible as some make it sound. There are quite a few simple things that are done now, or in the past, but were dismantled and led to the current problems. There were much more knowledgeable people than me working on it, including Volker. An international working group formed last year did release a 500pg. paper of recommendations. It is floating around the blogosphere somewhere. I just read the summary, but a lot of it is stuff that sounds so obvious, that is was shocking to me that things could have been allowed to work otherwise.
    So we still need regulators that do their jobs, and somehow keep the system from being corrupted. But that has always been the challenge of having a democracy.
    Hello ppcm
    You’re scaring me.

  26. DickF

    As long as you don’t realize the regulators are the crooks you will live in a fantasy world.
    Take a look at this youtube where Democrat Alan Grayson asks questions of the Inspector General of the Federal Reserve
    then study Franklin Raines tenure at Fannie Mae.

  27. Anonymous

    Although dickf is often ridiculed on this forum, he is correct about Fannie mae’s extortion or arbitrage of it’s GSE status. Menzie likes to hold them blamesless, but at 50%of the industry, Raines May have been the smartest msn in the room. At least he appears to have fooled Barney Frank.

  28. Get Rid of the Fed

    MikeR said: “On controlling the economy with an interest rate…”

    It seems to me that the fed is actually trying to control debt levels with interest rates, and that is not the only way they attempt to control debt levels.

    It also seems to me that the taylor rule does not work well at either extreme of debt (too much or too little).

  29. Spry

    Excellent paper professor. Simple idea but very nicely done.
    I have one apprehension though. You conclude with the simulations that a more inertial path causes output to be more variable. This is true if the actual fed policy rule is more inertial. What you measure in the paper is the market’s expectations of that rule. Is there a mapping between what the market thinks and what the fed actually did? I guess I’m worried if the market thought the rule was inertial but it actually wasn’t. There might still be interesting implications of that, just not the same as that implied by your simulations.

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