### Challenges Associated with Using Rules to Make Monetary Policy

In deciding how best to adjust monetary policy over time, the Federal Open Market Committee (FOMC) takes into account a wide range of information. This information includes the prescriptions for the federal funds rate provided by policy rules.1 While policy rules incorporate several key principles for good monetary policy and can be useful benchmarks for policymakers, such rules have important limitations that argue against mechanically following any rule.

Some academic research on policy rules contends that tying monetary policy to a simple and unvarying policy rule can simplify the central bank's communications with the public and make monetary policy predictable and relatively easy to understand. On this argument, following a simple policy rule could potentially enhance the effectiveness of monetary policy by helping guide households' and businesses' expectations of future economic and financial conditions--expectations that influence consumer spending and business investment (see Monetary Policy: What Are Its Goals? How Does It Work? for a discussion of the importance of expectations in the transmission of monetary policy to the broader economy).

The conclusions of this academic research depend on a number of assumptions that are unlikely to hold in the real world. For example, this research assumes that the structure of the economy is well understood by policymakers and the public, and that the economy can be represented fairly accurately by a small number of equations. However, the true structure of the economy is not known for certain; it is highly complex, and the simple models used by researchers do not capture that complexity. Furthermore, in the real world, the structure of the economy changes over time, and those changes are not apparent immediately.

For instance, in the wake of the Global Financial Crisis, the value of the neutral federal funds rate in the longer run (adjusted for inflation)--represented as $r^{LT}$--appears to have declined in economies around the world.2 Estimates for the United States suggest that $r^{LT}$ has declined from a bit more than 2 percent before the Global Financial Crisis to about 1 percent or less in recent years.3 In the forecasts that each member of the Board of Governors and each Federal Reserve Bank president submits each quarter--forecasts that are published in the Summary of Economic Projections--the median of the projected longer-run federal funds rate adjusted for inflation has declined from 2.25 percent in January 2012 to 0.75 percent in September 2017.4 The lower level of $r^{LT}$ is thought to be related to a number of factors, including a slower rate of productivity growth, demographic shifts associated with the aging of the population, global patterns of saving and investment, and a shift toward greater demand for "safe" assets.5 Many of these factors seem likely to persist, which suggests that neutral rates may remain low for some time to come.

If monetary policy were tied to a simple rule, policymakers would need to change or amend the rule to take account of the fall in the value of $r^{LT}$. Failing to do so would result in policy mistakes. In such situations, the rule might not aid the clarity of the central bank's communications or the public's understanding of monetary policy. In fact, amendments to the policy rule--particularly if they occurred frequently--could damage the central bank's reputation and the credibility of its policy (see Historical Approaches to Monetary Policy for a discussion of policy approaches that central banks have taken in the past and the important role that public confidence has played in their success or failure).

The economic models that academic researchers typically use to study the implications of following a simple policy rule also assume that any unexpected events that will affect the economy in the future will resemble unexpected events that occurred in the past--that is, that the types and range of shocks affecting the economy in the future will not be all that different from the shocks that have hit the economy before. But in practice, the nature and magnitude of the shocks hitting the economy can and do change over time. A simple policy rule that leads to good economic performance under one constellation of shocks is not guaranteed to lead to similarly good performance under a different constellation of shocks.

Moreover, the academic research literature on policy rules typically assumes that households and businesses would fully and immediately understand what the rule would tell the central bank to do in all future economic scenarios as well as the implications of the central bank's policy actions for the economy. If these assumptions do not hold in the real world, then the benefits that the models claim for simple rules will not be fully realized.

Finally, the models economists use to analyze simple rules typically assume that the upside and downside risks to the economy are balanced, or "symmetric." In some circumstances, the risks surrounding the economic outlook may be highly skewed or asymmetric. Simple policy rules do not take such asymmetries into account.

An example serves to illustrate the role that risk management can play in monetary policy: The nominal federal funds rate (the actual rate, not adjusted for inflation) has an effective lower bound (ELB) because it cannot be reduced materially below zero. Economic research has shown that, in the wake of the Global Financial Crisis, the value of $r^{LT}$ is lower than was the case before the crisis, implying that the federal funds rate will, in normal times, be closer to its ELB than was the case prior to the crisis. If the federal funds rate is close to the ELB in normal times, policymakers may not be able to cut the federal funds rate enough to offset shocks in the future that reduce aggregate demand for goods and services and raise unemployment.6 Policymakers need to take this risk into account when setting policy today. Over the past few years, with the federal funds rate still very close to zero, the FOMC has recognized that it would have limited scope to respond to an unexpected weakening in the economy by cutting the federal funds rate, but that it would have ample scope to increase the policy rate in response to an unexpected strengthening in the economy. This asymmetric risk has provided a sound rationale for increasing the federal funds rate more gradually than prescribed by some simple rules. As discussed in Policy Rules and How Policymakers Use Them, it is possible to specify a rule that does respond to this risk--the ELB-adjusted rule, for example. But many policy rules do not explicitly take this consideration into account.

Asymmetric risk need not always provide a rationale for a more gradual path; if the risks were strongly tilted toward substantial and persistent overheating and too-high inflation, the asymmetric risk could argue for higher rates than prescribed by simple rules.7

As noted earlier, some academic research on policy rules contends that tying monetary policy to a simple and unvarying policy rule could potentially enhance the effectiveness of monetary policy by helping guide households' and businesses' expectations of future economic and financial conditions. It is important to note that the central bank does not have to tie monetary policy to a simple rule to gain the benefits of managing expectations. Experience and the academic research literature indicate that a clear commitment to explicit goals, in conjunction with policy transparency and clear communication that allows the public to understand how the central bank's policy actions relate to its goals, is another way to obtain those benefits; these key features of the policy framework are followed by the Fed and other major central banks today.8 In Monetary Policy Strategies of Major Central Banks, we review that framework.

1. The FOMC routinely consults policy rules in its deliberations and has done so since 2004. For examples of these rules, see Policy Rules and How Policymakers Use Them. Return to text

2. The neutral federal funds rate in the longer run is the inflation-adjusted value of the federal funds rate that is expected to be consistent, on average, with sustaining maximum employment and inflation at the FOMC's 2 percent longer-run objective. See Thomas Laubach and John C. Williams (2003), "Measuring the Natural Rate of Interest," Review of Economics and Statistics, vol. 85 (November), pp. 1063-70; and Kathryn Holston, Thomas Laubach, and John C. Williams (2017), "Measuring the Natural Rate of Interest: International Trends and Determinants," Journal of International Economics, vol. 108 (May), pp. S59-75. In the academic research literature, the variable $r^{LT}$ is usually referred to as $r^*$. Return to text

3. Between 1960 and 2007, the federal funds rate adjusted for inflation--measured as the nominal federal funds rate less trailing four-quarter core PCE (personal consumption expenditures) inflation--averaged 2½ percent. Return to text

4. Each member of the Board of Governors and each Federal Reserve Bank president submits projections for the most likely outcomes for real output growth, the unemployment rate, and inflation over the next several years and in the longer run in conjunction with the FOMC meetings in March, June, September, and December. Each individual's forecast is based on his or her assessment of appropriate monetary policy, including a path for the federal funds rate and its longer-run value. "Appropriate monetary policy" is defined as the future path of policy that each individual deems most likely to foster outcomes for economic activity and inflation that best satisfy his or her interpretation of the Federal Reserve's objectives of maximum employment and stable prices. See the September 2017 Summary of Economic Projections, available on the Board's website at https://www.federalreserve.gov/monetarypolicy/fomcminutes20170920ep.htm. Return to text

5. For some background on these issues, see, for example, Etienne Gagnon, Benjamin K. Johannsen, and David López-Salido (2016), "Understanding the New Normal: The Role of Demographics," Finance and Economics Discussion Series 2016-080 (Washington: Board of Governors of the Federal Reserve System, October); Ben S. Bernanke (2005), "The Global Saving Glut and the U.S. Current Account Deficit," speech delivered at the Sandridge Lecture, Virginia Association of Economists, Richmond, Va., March 10; and Marco Del Negro, Domenico Giannone, Marc P. Giannoni, and Andrea Tambalotti (2017), "Safety, Liquidity, and the Natural Rate of Interest (PDF)," Brookings Papers on Economic Activity, Spring, pp. 235-94. Return to text

6. In macroeconomic model simulations, when the neutral value of the real federal funds rate in the longer run is 2 percent or lower, the ELB binds frequently and inflation falls, on average, short of the 2 percent objective. For a discussion of this issue, see Michael T. Kiley and John M. Roberts (2017), "Monetary Policy in a Low Interest Rate World," Finance and Economics Discussion Series 2017-080 (Washington: Board of Governors of the Federal Reserve System, August). Return to text

7. For a discussion of how risks to financial stability could be incorporated into a monetary policy framework, see Jeremy C. Stein (2014), "Incorporating Financial Stability Considerations into a Monetary Policy Framework," speech delivered at the International Research Forum on Monetary Policy, Washington, March 21. Return to text

8. See Mervyn King (1994), "The Transmission Mechanism of Monetary Policy (PDF)," Bank of England Quarterly Bulletin, August, pp. 261-67; and Lars E.O. Svensson (2017), "What Rule for the Federal Reserve? Forecast Targeting (PDF)," paper presented at "Are Rules Made to Be Broken? Discretion and Monetary Policy," 61st Economic Conference of the Federal Reserve Bank of Boston, Boston, October 13. Return to text