Policy Rule Legislation in Practice Alex Nikolsko-Rzhevskyy Lehigh University David Papell and Ruxandra Prodan University of Houston

Federal Reserve Accountability and Transparency Act Negative Reaction Janet Yellen – A “grave mistake” which would “essentially undermine central bank independence.” Alan Blinder – In a town like Washington, the message to the Fed would be clear. Depart from the original Taylor rule at your peril.” Janet Yellen – “I’m not a proponent of chaining the Federal Open Market Committee in its decision making to any rule whatsoever.” Positive Reaction Allan Meltzer – “So you need a rule which says, look, you said you were going to do this, and you have not done it. That requires an answer, and that I think is one of the most important reasons why we need some kind of a rule.”

Objective of the Paper Suppose that Policy Rule Legislation Enacted for Past 60 Years When Would the Fed Have Been in Compliance? When Would Deviations Have “Required an Answer”? (Meltzer) We Consider Several Rules Over Different Periods Original Taylor Rule Modified Taylor Rule with Higher Output Gap Coefficient What Does it Mean to be Out of Compliance? The Fed Chooses and Can Change the Rule Trivial Compliance by Frequent Changes in the Rule Focus on Compliance Over Extended Periods

Policy Rules Legislation Federal Reserve Accountability and Transparency Act of 2014 House of Representatives Bill Directive Policy Rule Chosen by the Fed Describes How Policy Instrument Would Respond to a Change in the Intermediate Policy Inputs Deviations from the Rule Fed Chair Required to Testify Before Appropriate Congressional Committees Statement Whether Directive Policy Rule Substantially Conforms to the Reference Policy Rule Original Taylor Rule

Policy Rules Legislation Financial Regulatory Improvement Act of 2015 Draft Senate Bill Policy Rule Similar to Directive Policy Rule Chosen by the Fed No Equivalent to Reference Policy Rule Replace Semi-Annual Monetary Policy Report to Congress by the Federal Reserve Board with Quarterly Report by the FOMC Continues Semi-Annual Testimony by Fed Chair

Policy Rules Legislation Neither Bill Defines a Deviation What Does “Out of Compliance” mean? Nikolsko-Rzhevskyy, Papell, and Prodan (2014) Paper Presented at Hoover Conference Last May Statistical Methods to Determine Rules-Based and Discretionary Eras Deviations from Original Taylor Rule Less Than/Greater Than 2 Percent Correlation of 0.8 with Rules-Based/Discretionary Eras We Define Deviations as Greater than Two Percent from Prescribed Rule

Policy Rules Original Taylor (1993) Rule FFR = 1.0 + 1.5 Inflation + 0.5 Output Gap Time-Varying Equilibrium Real Interest Rate FFR = -1.0 + 1.5 Inflation + 0.5 Output Gap + TVERIR Modified Taylor Rule – Yellen (2012) Balanced Approach Rule FFR = 1.0 + 1.5 Inflation + 1.0 Output Gap

Policy Rules From 1954 to 2015 Federal Funds Rate Data from 1954:Q3 – 2015:Q1 Zero Lower Bound Use Shadow FFR from Wu and Xia (2014). Negative Starting in 2009:Q1 Real-Time Data That Was Publicly Available GDP and GDP Deflator from Philadelphia Fed Construct Output Gaps with Linear Detrending Until 1973 and Quadratic Detrending Thereafter Congruence with Real-Time Okun’s Law Gaps We Don’t Use Greenbook Output Gap or Inflation Forecast Data Moral Hazard Problem (Perceived or Actual) Original and Modified Taylor Rules

Original Taylor Rule: 1954-2015

Modified Taylor Rule: 1954-2015

Policy Rules From 1954 to 2015 Taylor (1999) “too high in the early 1960s, too low in the late 1960s, to low in the 1970s, on track in 1979-1981, too high in 1982-1984, and on track in the late 1980s and 1990s.” No Need to Modify Quote for Real-Time Data Justification for Deviations Inflation Forecasts Don’t Work for the 1970s Deviations Starting in 1976:Q1 with Original Taylor Rule Credibility in the Early 1980s Virtually No Deviations in the Great Moderation Mixed Results in the 2000s

Policy Rules From 1991 to 2015 Congressional Budget Office Real-Time Output Gaps CBO Real-Time Potential GDP and Philadelphia Fed Real-Time GDP Poole (2007) and Taylor (2007) CPI Inflation Kohn (2007) Core CPI Inflation Bernanke (2010) Core PCE Inflation (Proxy for Inflation Forecasts) Yellen (2012) Modified Taylor Rule with PCE Inflation Yellen (2015) Original Taylor Rule with TVERIR (Revised and Real-Time)

Original Taylor Rule with Real-Time CBO Output Gaps and CPI Inflation: 1994-2015

Original Taylor Rule with Real-Time CBO Output Gaps and PCE Inflation: 1991-2015

Original Taylor Rule with Real-Time CBO Output Gaps and Core CPI Inflation: 1999-2015

Original Taylor Rule with Real-Time CBO Output Gaps and Core PCE Inflation: 1996-2015

Modified Taylor Rule with Real-Time CBO Output Gaps and PCE Inflation: 1991-2015

Original Taylor Rule with Real-Time CBO Output Gaps, PCE Inflation and Time-Varying Equilibrium Real Interest Rates: 1991-2014

Policy Rules From 1991 to 2015 Poole (2007) and Taylor (2007) Deviations in 2003-2005 Deviations in 2011 to 2015 Alternative Policy Rules and Inflation Measures Eliminate Deviations for Targeted Period Creates Deviations for Previous and Subsequent Periods

Conclusions Policy Rule Legislation from 1954 to 2015 Policy Generally in Compliance from 1954 to 1975 Exception for Late 1960s Policy Generally Not in Compliance from 1975 to 1985 Great Inflation and Volcker Disinflation Policy in Compliance During Great Moderation Mixed Results for the 2000s and 2010s Rules that Produce Compliance for One Period Cause Violations of Compliance in Other Periods Pessimistic that Rules for which the Fed is in Compliance Today Will Provide Compliance Going Forward