Insight Line—July 23, 2007

For the past few years, investors have been routinely subjected to hearing about the Federal Open Market Committee’s (FOMC) move toward a “rules-based” approach to monetary policy. In my view, one such rule, the Taylor Rule, is of particular interest as Wall Street has come to believe the FOMC will remain on hold with adjusting the federal funds rate for the rest of the year.

Named for its creator, John B. Taylor,¹ the rule offers guidance for how a central bank’s monetary policymakers should set short-term interest rates. The calculation, based the economy’s perceived long-term growth and the level of inflation, essentially defines the federal funds rate necessary to achieve optimal levels of inflation and employment in our economy. Simply put, the Taylor Rule maintains that the FOMC should raise short-term interest rates when the targeted federal funds rate is below that calculated by the rule and vice versa. In fact, some in academia argue that the rule is accurate enough to be the public face of monetary policy from the FOMC.

However, the transition toward incorporating a rules-based influence into monetary policy had a rough start. Then FOMC Chairman Alan Greenspan suggested, at a summer symposium, “rules by their nature are simple, and when significant and shifting uncertainties exist in the economic environment, they cannot substitute for risk-management paradigms, which are far better suited to policymaking.”² After all, he went on to say, the certainty of the rule’s prescription is highly dependent upon the validity of the data.

Such public dialogue on the cost/benefit of rules-based policy spurred numerous Federal Reserve Bank researchers to weigh in on the issue of monetary policy and data uncertainty. However, it was an article by Sharon Kozicki, an economist at the Federal Reserve Bank of Kansas City, entitled “How Do Data Revisions Affect the Evaluation and Conduct of Monetary Policy”³ that caught the attention of FOMC members including Dr. Ben Bernanke, who now serves as Chairman of the FOMC.

In her article, Ms. Kozicki examined the complications of conducting monetary policy based on data subject to revisions (and many economic indicators are revised over time). According to her study, “Gradualism reduces the effect of uncertainty on policy recommendations but does not eliminate it. The range of policy recommendations is narrower on average when based on a gradualist policy.” At the risk of oversimplification, she essentially concludes that haste makes waste.

As I see it, the implications for the FOMC’s latest directives are worth noting. In particular, I believe the Taylor Rule and Kozicki’s findings shed some light on the FOMC’s choice of the words “convincingly demonstrated” with respect to recent inflation trends. In their June 28, 2007 Monetary Directive press release, the FOMC states, “Readings on core inflation have improved modestly in recent months. However, a sustained moderation in inflation pressures has yet to be convincingly demonstrated.” In other words, though recently released inflation data supports the FOMC’s forecasted reduction to inflationary pressures; one number does not a trend make. Otherwise, as the chart below depicts,⁴ the Taylor Rule asserts that the FOMC should have reduced the overnight lending rate earlier in the year. Yet, under a gradualist approach, such an immediate action is out of the question in that subsequent data revisions might prove the action unwarranted.

However, as Ms. Kozicki cautions, when enough data is available for the committee to make a learned decision it is ill advised to delay, as the ancillary costs to the economy may be too great.

¹ John B. Taylor served as the Undersecretary of the Treasury for International Affairs in the first term of the Bush Administration (2001-2005), is senior fellow at the Hoover Institution, and the Mary and Robert Raymond professor of economics at Stanford University.

² Greenspan, Alan, “Monetary Policy Under Uncertainty,” remarks at a symposium sponsored by the Federal Reserve Bank of Kansas City, Jackson Hole, Wyoming, August 29, 2003, pages 3-4.

³ Kozicki, Sharon, “How Do Data Revisions Affect the Evaluation and Conduct of Monetary Policy?” The Federal Reserve Bank of Kansas City, Economic Review, First Quarter 2004, page 25.

⁴ Ned Davis Research, Inc, ©2007