Taylor rule and the associated policy approach.

For several decades now, the Fed and other central banks have worked to anchor inflation expectations in the vicinity of 2 percent and to explain the associated policy approach. Economics professor John Taylor, author of the “Taylor rule, argues the Federal Reserve should raise interest rates. While the Taylor principle has proved very influential, there is more debate about the other terms that should enter into the FOMC policy making, factors that policymakers must consider i practice.

Although the Federal Reserve does not explicitly follow the Taylor rule, the rule provides a fairly accurate summary of US monetary policy (under Paul Volcker and Alan Greenspan). Former Fed Chair Dr. Bernanke explains and discuss particular, the Taylor Rule here at his Brookings blogg: , but also changes in the structure of the economy and the channels of monetary policy transmission.

The United States’ economy is approaching full employment and may already be there. The overall unemployment rate is down to just 5.5%, and the unemployment rate among college graduates is just 2.5%. The return to full employment reflects the Federal Reserve’s strategy of “unconventional monetary policy” – the combination of massive purchases of long-term assets known as quantitative easing (QE) and its promise to keep short-term interest rates close to zero.

After a very slow initial recovery, real GDP began growing at annual rates of more than 4% in the second half of 2013. Consumer spending and business investment continued at that rate in 2014. That strong growth raised employment and brought the economy to full employment. But the Fed’s unconventional monetary policies have also created dangerous risks to the financial sector and the economy as a whole. The low level of all interest rates that resulted from this policy drove investors to buy equities and to increase the prices of owner-occupied homes. As a result, the net worth of American households rose by $10 trillion in 2013, leading to increases in consumer spending and business investment.

Moreover, low interest rates have created a new problem, : liquidity mismatch. Recent project syndicate post by Martin Feldstein, Professor of Economics at Harvard University, looks at how low-interest-rate environment has also caused lenders to take extra risks in order to sustain profits. “A situation that the Fed now faces as it considers “normalizing” monetary policy. Some members of the Federal Open Market Committee (FOMC, the Fed’s policymaking body) therefore fear that raising the short-term federal funds rate will trigger a substantial rise in longer-term rates, creating losses for investors and lenders, with adverse effects on the economy. Others fear that, even without such financial shocks, the economy’s current strong performance will not continue when interest rates are raised”.

And still other FOMC members want to hold down interest rates in order to drive the unemployment rate even lower, despite the prospects of accelerating inflation and further financial-sector risks. These changes provide a further rationale for looking beyond simple monetary rules, which cannot capture the full complexity involved in determining appropriate monetary policy, especially during periods when economic relationships may be changing. So interest rates have to be set based on judgments about what inflation might be – the outlook over the coming few years – not what it is today. The Taylor rule proposed in the early 1990s is a formula that stipulates what the Fed’s benchmark rate should be based on inflation and the level of economic growth.

Importantly, the US Federal Reserve is having second thoughts about “when” to raise interest rates. US central bank’s decision on interest, therefore, may change the shape of the global recovery. Fed increases are powerful tsunamis — within hours, their effects are felt even on the furthest shores.

 

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