Board of Governors of the Federal Reserve System

On August 27, 2020, the Federal Open Market Committee (FOMC) issued a revised Statement on Longer-Run Goals and Monetary Policy Strategy.¹ This document, first released in January 2012, lays out the Committee's goals, articulates its framework for monetary policy, and serves as the foundation for its policy actions. The revised statement encapsulates the key conclusions from the Federal Reserve's review of the monetary policy strategy, tools, and communication practices it uses to pursue its statutory dual-mandate goals of maximum employment and price stability.

The review, which commenced in early 2019, was undertaken because the U.S. economy has changed in ways that matter for monetary policy. In particular, the neutral level of the policy interest rate—the policy rate consistent with the economy operating at full strength and with stable inflation—has fallen over recent decades in the United States and abroad. This decline in the neutral policy rate increases the risk that the effective lower bound (ELB) on interest rates will constrain central banks from reducing their policy interest rates enough to effectively support economic activity during downturns. In addition, during the economic expansion that followed the Global Financial Crisis—the longest U.S. expansion on record—the unemployment rate hovered near 50-year lows for roughly 2 years, resulting in new jobs and opportunities for many who have typically been left behind. At the same time, with brief exceptions, inflation ran below the Committee's 2 percent objective.

The revised statement begins by reaffirming the Committee's commitment to its statutory mandate from the Congress to promote maximum employment, price stability, and moderate long-term interest rates. It also describes the benefits of explaining policy actions to the public as clearly as possible. The statement then outlines important changes to the characterization of the Committee's policy framework for achieving its dual-mandate goals of maximum employment and price stability. After stating that economic variables fluctuate in response to disturbances and that monetary policy plays an important role in stabilizing the economy, the statement notes that the Committee's primary means of adjusting policy is through changes in the policy interest rate (the target range for the federal funds rate). Furthermore, because the neutral level of the policy rate is now lower than its historical average, "the federal funds rate is likely to be constrained by its effective lower bound more frequently than in the past." Therefore, "the Committee judges that downward risks to employment and inflation have increased." The statement then notes that the "Committee is prepared to use its full range of tools to achieve its maximum employment and price stability goals," indicating that it could deploy other policy tools, such as forward guidance and asset purchases, when the policy rate is at its ELB.

In its revised statement, the Committee characterizes maximum employment as a "broad-based and inclusive goal" in addition to saying—as it did in the 2012 statement—that maximum employment is not directly measurable and that it changes over time and depends largely on nonmonetary factors. During the Fed Listensevents that were a pillar of the review of monetary policy strategy, tools, and communication practices, policymakers heard from a broad range of stakeholders in the U.S. economy about how monetary policy affects peoples' daily lives and livelihoods.²

A key takeaway from these events was that a strong labor market during the late stages of an economic expansion—conditions that were in effect in 2019 and early 2020—offers significant benefits to residents of low- and moderate-income communities, primarily by providing employment opportunities for people who have had difficulty finding jobs in the past.

The revised statement says that "the Committee's policy decisions must be informed by assessments of the shortfalls [emphasis added] of employment from its maximum level" rather than by "deviations"—the word used in the earlier statement.³ In previous decades, inflation tended to rise noticeably in response to a strengthening labor market. It was sometimes appropriate for the Fed to tighten monetary policy as employment rose toward its estimated maximum level in order to stave off an unwelcome rise in inflation. The change to "shortfalls" clarifies that, in the future, the Committee will not have concerns when employment runs at or above real-time estimates of its maximum level unless accompanied by signs of unwanted increases in inflation or the emergence of other risks that could impede the attainment of the dual-mandate goals.

The Committee's longer-run goal for inflation remains 2 percent, unchanged from the 2012 statement.⁴ The revised statement emphasizes that the FOMC's policy actions to achieve maximum employment and price stability will be most effective if longer-term inflation expectations remain well anchored at 2 percent. However, if inflation runs below 2 percent following economic downturns but never moves above 2 percent even when the economy is strong, then, over time, inflation will average less than 2 percent. Households and businesses will come to expect this result, meaning that inflation expectations would tend to move below the 2 percent inflation goal and pull down realized inflation. Lower inflation expectations also pull down the level of nominal interest rates, further diminishing the scope for monetary policy to reduce the policy rate during a downturn and further worsening economic outcomes. To prevent inflation expectations from falling below 2 percent and the adverse cycle that could ensue, the statement indicates that "the Committee seeks to achieve inflation that averages 2 percent over time, and therefore judges that, following periods when inflation has been running persistently below 2 percent, appropriate monetary policy will likely aim to achieve inflation moderately above 2 percent for some time."

The revised statement acknowledges that "sustainably achieving maximum employment and price stability depends on a stable financial system." Therefore, as with the 2012 statement, the Committee's policy decisions will take into account "its assessments of the balance of risks, including risks to the financial system that could impede the attainment" of the statutory goals.

The Committee concludes its revised statement by indicating its intention to undertake a review of the Federal Reserve's monetary policy strategy, tools, and communication practices roughly every five years. Conducting a review at regular intervals is a good institutional practice, provides valuable feedback, and enhances transparency and accountability.

Simple interest rate rules relate a policy interest rate, such as the federal funds rate, to a small number of other economic variables—typically including the deviation of inflation from its target value and a measure of resource slack in the economy. Policymakers consult policy rate prescriptions derived from a variety of policy rules as part of their monetary policy deliberations without mechanically following the prescriptions of any particular rule. Most rules analyzed in the research literature respond to deviations—both positive and negative—of resource utilization from its longer-run level because their design was informed by historical periods and economic models in which high resource utilization and a strong labor market are accompanied by inflation pressure and in which policy rates remain well above the effective lower bound (ELB).

Economic performance in recent decades, including during the previous economic expansion, has demonstrated that a strong labor market can be sustained without inducing an unwanted increase in inflation. During that expansion, the unemployment rate fell to low levels—it remained at or below 4 percent from early 2018 until the start of the pandemic—bringing many benefits to families and communities that, all too often, had been left behind, with no sign of excessive pressures on prices. The lack of undue inflation pressures during this period illustrates that a strong labor market, by itself, need not cause concern unless accompanied by signs of unwanted increases in inflation or the emergence of other risks that could impede the attainment of the Committee's goals. In addition, the expansion reinforced the view that assessments of the maximum level of employment are imprecise and may change over time.¹ Tightening monetary policy in the absence of evidence of excessive inflation pressures may result in an unwarranted loss of opportunity for many Americans, whereas if an undue increase in inflation were to arise, policymakers would have the tools to address such an increase. Reflecting these considerations, the Federal Open Market Committee's (FOMC) revised Statement on Longer-Run Goals and Monetary Policy Strategy refers to "shortfalls of employment" from the Committee's assessment of its maximum level rather than the "deviations of employment" used in the previous statement.² This change has important implications for the design of simple interest rate rules.

This discussion examines the prescriptions from a number of commonly studied monetary policy rules, along with the prescriptions from a modified simple rule that, all else being equal, would not call for increasing the policy rate as employment moves higher and unemployment drops below its estimated longer-run level. This modified rule aims to illustrate, in a simple way, the Committee's focus on shortfalls of employment from assessments of its maximum level. Other key changes to the Committee's monetary policy strategy, including the aim of having inflation average 2 percent over time to ensure that longer-term inflation expectations remain well anchored, are not incorporated in the simple rules analyzed in this discussion.

Policy Rules: Some Key Design Principles and Limitations

In many stylized models of the economy, desirable economic outcomes can be achieved by following a monetary policy rule that incorporates key principles of good monetary policy. One such principle is that monetary policy should respond in a predictable way to changes in economic conditions, thus fostering public understanding of policymakers' goals and strategy.³ A second principle is that, to stabilize inflation, the policy rate should be adjusted over time in response to persistent increases or decreases in inflation to an extent sufficient to ensure a return of inflation to the longer-run objective.

Simple monetary policy rules also have important limitations. A first limitation is that many formulations of simple rules do not recognize that the ELB limits the extent that the policy rate can be lowered to support the economy, which may impart a downward bias to both inflation and inflation expectations. As part of the FOMC's revised strategy to mitigate the challenges posed by the ELB and anchor longer-term inflation expectations at 2 percent, the Committee states that it "seeks to achieve inflation that averages 2 percent over time, and therefore judges that, following periods when inflation has been running persistently below 2 percent, appropriate monetary policy will likely aim to achieve inflation moderately above 2 percent for some time." None of the simple rules analyzed in this discussion take into account average inflation performance or developments in measures of inflation expectations. As such, they do not reflect this important aspect of the FOMC's monetary policy strategy.⁴

A second limitation is that simple rules respond to only a small set of economic variables and thus necessarily abstract from many of the considerations taken into account by the FOMC. For example, a simple rule might respond to movements in a specific labor market indicator, such as the overall unemployment rate. However, no single labor market indicator can precisely capture the size of the shortfall from maximum employment or identify when a strong labor market can be sustained without putting undue upward pressure on inflation.⁵ A third limitation of simple rules for the policy rate is that they generally do not recognize the fact that the monetary policy toolkit includes other tools—notably, large-scale asset purchases and forward guidance, which are especially relevant when the policy rate is near or at the ELB.

Policy Rules: Historical Prescriptions

Economists have analyzed many monetary policy rules, including the well-known Taylor (1993) rule, the "balanced approach" rule, the "adjusted Taylor (1993)" rule, and the "first difference" rule.⁶ In addition to these rules, figure A shows a "balanced approach (shortfalls)" rule, which represents one simple way to illustrate the Committee's focus on shortfalls from maximum employment. All of the policy rules analyzed in this discussion embody the key principles of good monetary policy previously noted. They are also subject to the associated limitations. Thus, the balanced-approach (shortfalls) rule, as is the case with all simple rules, does not fully capture the monetary policy strategy that the FOMC announced in August 2020.

All five rules feature the unemployment rate gap, measured as the difference between an estimate of the rate of unemployment in the longer run ($$ u_t^{LR}$$) and the current unemployment rate; the first-difference rule includes the change in the unemployment rate gap rather than its level.⁷ All of the rules abstract from the uncertainty affecting estimates of the unemployment rate gap. In addition, all of the rules include the difference between inflation and the FOMC's longer-run objective of 2 percent. All but the first-difference rule include an estimate of the neutral real interest rate in the longer run ($$ r_t^{LR}$$).⁸

By construction, the balanced-approach (shortfalls) rule prescribes identical policy rates to those prescribed by the balanced-approach rule at times when the unemployment rate is above its estimated longer-run level. However, when the unemployment rate is below that level, the balanced-approach (shortfalls) rule is more accommodative than the balanced-approach rule because it does not call for the policy rate to rise as the unemployment rate drops further.

Contrary to the other simple rules featured here, the adjusted Taylor (1993) rule recognizes that the federal funds rate cannot be reduced materially below the ELB. To make up for the cumulative shortfall in accommodation following a recession during which the federal funds rate has fallen to its ELB, the adjusted Taylor (1993) rule prescribes only a gradual return of the policy rate to the (positive) levels prescribed by the standard Taylor (1993) rule after the economy begins to recover.

Figure B shows historical prescriptions for the federal funds rate from the five rules. For each period, the figure reports the policy rates prescribed by the rules, taking as given the prevailing economic conditions and estimates of $$ u_t^{LR}$$ and $$ r_t^{LR}$$ at the time. The four rules whose formulas do not impose the ELB imply prescriptions of strongly negative policy rates in response to the pandemic-driven recession, well below their respective troughs in the 2008–09 recession. These deeply negative prescribed policy rates show the extent to which policymakers' ability to support the economy through cuts in the policy rate was constrained by the ELB during the pandemic-driven recession—a constraint that helped motivate the FOMC's other policy actions at the time, including forward guidance and asset purchases.

Regarding the recovery from the 2008–09 recession, all of the simple rules shown here prescribe departure from the ELB well before the FOMC determined that it was appropriate to do so. The FOMC's judgment that it was appropriate to maintain a more accommodative path of the federal funds rate than prescribed by these rules was informed by a wide range of information, including measures of labor market conditions, indicators of inflation pressures and inflation expectations, and readings on financial and international developments.

The balanced-approach (shortfalls) rule calls for lower policy rates than the balanced-approach rule at times when unemployment is below its estimated longer-run level, thus providing somewhat more policy accommodation during the 2006–07 period and from late 2016 until the start of the pandemic. The fact that the policy rate prescriptions for the balanced-approach and balanced-approach (shortfalls) rules coincide from the 2008–09 recession up to the end of 2016 reflects the slow recovery in this period, during which unemployment remained above real-time estimates of its longer-run level.

Although these two rules prescribe identical policy rates over most of the period shown, including departure from the ELB about two years before the actual departure in December 2015, one should not conclude that they generally offer a similar degree of policy accommodation. Had the previous economic expansion not been cut short by the pandemic, the balanced-approach (shortfalls) rule would likely have continued to prescribe a lower policy rate than the balanced-approach rule. In addition, knowledge on the part of households and businesses that policymakers will respond to shortfalls rather than deviations from maximum employment can, in practice, help foster more accommodative financial conditions even when employment is below its maximum level because financial conditions are affected by the expected path of the policy rate. Expectations of lower policy rates in the future—once employment has recovered—can reduce longer-term interest rates, support accommodative financial conditions, and encourage aggregate spending in the present. These observations underline the importance of communication about future policy actions and demonstrate how a shift in focus to employment shortfalls, in the context of a simple rule, can provide more policy accommodation—even during times like today when employment remains depressed.