The Costs and Benefits of Deviating from the Systematic Component of Monetary Policy

featuring John B. Taylor
Friday, February 22, 2008

Recent turmoil in the financial markets raises questions about whether and by how much monetary policy should deviate from its regular, more systematic, responses to economic conditions. Whether it is examined from the perspective of investors (McCulley and Toloui (2008)), academic researchers (Bauducco, Bulir, and Cihak (2008)), or policy makers (Mishkin (2008)), the question is essentially the same: How should interest rate decisions differ from the recommendations of a simple Taylor rule during times of financial market stress?

I was invited to address this question tonight and I am delighted to do so. I begin by reviewing the traditional benefits of staying close to the prescriptions of simple policy rules, with an update from the experience of the past two decades. I then consider recent technical arguments in favor of temporarily deviating from policy rules. In my view some of these arguments leave too much scope for discretion and thereby introduce unpredictability or doubts about the commitment to return to more systemic responses. I believe more rule-like departures are preferable in situations like policymakers face now.

Classic Benefits from Staying on the Rule

I’ve been discussing the benefits of basing monetary policy decisions on the principles imbedded in policy rules for more years than I’d like to admit. I’d like to start by simply listing those benefits. None of the benefits requires that policy makers use a rule mechanically, but rather that their decisions are consistent with the general guidelines of a policy rule. At a minimum, policy makers have to use discretion in order to forecast or nowcast macroeconomic variables in the current quarter based on incoming monthly, weekly, and daily economic and financial data.

Read the full transcript: john_taylor_sf_fed_speech_2-22-08_.pdf