Board of Governors of the Federal Reserve System

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 current 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.

Recently, inflation has run well above the Committee's 2 percent longer-run objective, the U.S. economy has been very strong, and labor market conditions have been very tight. Against this background, the simple monetary policy rules considered in this discussion have called for raising the federal funds rate significantly. Starting in March, the Federal Open Market Committee (FOMC) began raising the target range for the federal funds rate and indicated that it anticipates that ongoing increases in the target range will be appropriate. The FOMC also began the process of significantly reducing the size of the Federal Reserve's balance sheet.

Selected Policy Rules: Descriptions

In many economic models, desirable economic outcomes can be achieved if monetary policy responds in a predictable way to changes in economic conditions. In recognition of this idea, 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.¹ 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.² These rules embody key design principles of good monetary policy, including that the policy rate should be adjusted forcefully enough over time to ensure a return of inflation to the central bank's longer-run objective and to anchor longer-term inflation expectations at levels consistent with that objective.

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All five rules feature the difference between inflation and the FOMC's longer-run objective of 2 percent. The five rules use 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.³ All but the first-difference rule include an estimate of the neutral real interest rate in the longer run ($$ r_t^{LR}$$).⁴

Unlike the other simple rules featured here, the adjusted Taylor (1993) rule recognizes that the federal funds rate cannot be reduced materially below the effective lower bound. To make up for the cumulative shortfall in policy accommodation following a recession during which the federal funds rate is constrained by its effective lower bound, the adjusted Taylor (1993) rule prescribes delaying the return of the policy rate to the (positive) levels prescribed by the standard Taylor (1993) rule until after the economy begins to recover.

Selected Policy Rules: Prescriptions

Figure B shows historical prescriptions for the federal funds rate under the five simple rules considered. For each quarterly period, the figure reports the policy rates prescribed by the rules, taking as given the prevailing economic conditions and survey-based estimates of $$ u_t^{LR}$$ and $$ r_t^{LR}$$ at the time. All of the rules considered called for a highly accommodative stance for monetary policy in response to the pandemic-driven recession. The recent elevated inflation readings imply that the prescriptions for the federal funds rate of simple policy rules in the first quarter of 2022 are well above their pre-pandemic levels, at between 4 percent and 7 percent. Overall, the prescriptions of all simple rules have risen notably over the past few quarters as inflation readings climbed further above 2 percent.

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Policy Rules: Limitations

Simple policy rules are also subject to important limitations. One important limitation is that simple policy rules do not take into account the other tools of monetary policy, such as large-scale asset purchases. A second important limitation is that simple rules respond to only a small set of economic variables and thus necessarily abstract from many of the factors that the FOMC considers when it assesses the appropriate setting of the policy rate. Another limitation is that most simple policy rules do not take into account the effective lower bound on interest rates, which limits the extent to which the policy rate can be lowered to support the economy. This constraint was particularly evident in the aftermath of the pandemic-driven recession, when the lower bound on the policy rate motivated the FOMC's other policy actions to support the economy. Finally, simple policy rules generally abstract from the risk-management considerations associated with uncertainty about economic relationships and the evolution of the economy. As a result, the usefulness of simple policy rules can be limited in unusual economic circumstances.⁵

With the Federal Reserve's net asset purchases concluding in March, the size of the balance sheet has been roughly stable at $9 trillion since February 2022 (figures A and B). At its May 2022 meeting, the FOMC announced plans for significantly reducing the size of the Federal Reserve's balance sheet starting June 1. Balance sheet reduction, along with increases in the target range for the federal funds rate, firms the stance of monetary policy.

A. Balance sheet comparison

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Despite the roughly constant total size of the balance sheet, reserves—the largest liability on the Federal Reserve's balance sheet—have continued to fall significantly since February 2022, reflecting growth in take-up at the overnight reverse repurchase agreement (ON RRP) facility (figure C).¹ In addition, the Treasury General Account (TGA)—another volatile liability—rose considerably upon larger than expected tax receipts and peaked just short of $1 trillion on June 2 before retracing the movement.

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Usage at the ON RRP facility has risen $496 billion since February 2022 to stand at a record $2.2 trillion at the time of this report. Low rates on repurchase agreements—reflecting abundant liquidity in the banking system and limited Treasury bill supply—have contributed to this increasingly elevated participation. In addition, uncertainty about the magnitude and pace of policy rate increases contributed to a preference for short-duration assets, like those provided by the ON RRP facility. The ON RRP facility is intended to help keep the effective federal funds rate from falling below the target range set by the FOMC, as institutions with access to the ON RRP should be unwilling to lend funds below the ON RRP's pre-announced offering rate. The facility continued to serve this intended purpose, and the set of administered rates—interest on reserve balances (IORB) and the ON RRP offering rate—was effective at raising and maintaining the effective federal funds rate within the target range during the policy rate adjustments that have taken place since March.

Going forward, the planned balance sheet decline will drain reserves from the banking system and add longer-duration assets, which will likely put upward pressure on short-term rates and reduce demand at the ON RRP facility. The Committee will monitor the evolution of reserves and other liabilities to ensure a smooth entry into efficient operation of monetary policy in an ample-reserves regime.