BOSTON (MNI) – The following is the fourth and final section of the
remarks of Federal Reserve Vice Chair Janet Yellen prepared Wednesday
for the Boston Economic Club:
Although simple rules provide a useful starting point in
determining appropriate policy, they by no means deserve the glast
wordh — especially in current circumstances. An alternative approach,
also illustrated in figure 10, is to compute an “optimal control” path
for the federal funds rate using an economic model — FRB/US, in this
case. Such a path is chosen to minimize the value of a specific gloss
functionh conditional on a baseline forecast of economic conditions.
The loss function attempts to quantify the social costs resulting from
deviations of inflation from the Committeefs longer-run goal and from
deviations of unemployment from its longer-run normal rate.19 The solid
green line with dots in figure 10 shows the goptimal controlh path for
the federal funds rate, again conditioned on the illustrative baseline
outlook.20 This policy involves keeping the federal funds rate close to
zero until late 2015, four quarters longer than the balanced-approach
rule prescription and several years longer than the Taylor rule.
Importantly, optimal control calls for a later lift-off date even though
this benchmark–unlike the simple policy rules — implicitly takes full
account of the additional stimulus to real activity and inflation being
provided over time by the Federal Reservefs other policy tool, the past
and projected changes to the size and maturity of its securities
holdings.21 Figure 11 shows that, by keeping the federal funds rate at
its current level for longer, monetary policy under the
balanced-approach rule achieves a more rapid reduction of the
unemployment rate than monetary policy under the Taylor (1993) rule
does, while nonetheless keeping inflation near 2 percent. But the
improvement in labor market conditions is even more notable under the
optimal control path, even as inflation remains close to the FOMCfs
long-run inflation objective.
As I noted, simple rules have the advantage of delivering good
policy outcomes across a broad range of models, and are thereby
relatively robust to our limited understanding of the precise working of
the economy — in contrast to optimal-control policies, whose
prescriptions are sensitive to the specification of the particular model
used in the analysis. However, simple rules also have their
shortcomings, leading them to significantly understate the case for
keeping policy persistently accommodative in current circumstances.
One of these shortcomings is that the rules do not adjust for the
constraints that the zero lower bound has placed on conventional
monetary policy since late 2008. A second is that they do not fully take
account of the protracted nature of the forces that have been
restraining aggregate demand in the aftermath of the housing bust. As
Ifve emphasized, the pace of the current recovery has turned out to be
persistently slower than most observers expected, and forecasters expect
it to remain quite moderate by historical standards. The headwinds that
explain this disappointing performance represent a substantial departure
from normal cyclical dynamics. As a result, the economyfs equilibrium
real federal funds rate — that is, the rate that would be consistent
with full employment over the medium run — is probably well below its
historical average, which the intercept of simple policy rules is
supposed to approximate. By failing to fully adjust for this decline,
the prescriptions of simple policy rules — which provide a useful
benchmark under normal circumstances — could be significantly too
restrictive now and could remain so for some time to come. In this
regard, I think it is informative that the Blue Chip consensus forecast
released in March showed the real three-month Treasury bill rate
settling down at only 1-1/4 percent late in the decade, down 120 basis
points from the long-run projections made prior to the recession.
Looking Ahead
Recent labor market reports and financial developments serve as a
reminder that the economy remains vulnerable to setbacks. Indeed, the
simulations I described above did not take into account this new
information. In our policy deliberations at the upcoming FOMC meeting we
will assess the effects of these developments on the economic forecast.
If the Committee were to judge that the recovery is unlikely to proceed
at a satisfactory pace (for example, that the forecast entails little or
no improvement in the labor market over the next few years), or that the
downside risks to the outlook had become sufficiently great, or that
inflation appeared to be in danger of declining notably below its 2
percent objective, I am convinced that scope remains for the FOMC to
provide further policy accommodation either through its forward guidance
or through additional balance-sheet actions. In taking these decisions,
however, we would need to balance two considerations.
On the one hand, our unconventional tools have some limitations and
costs. For example, the effects of forward guidance are likely to be
weaker the longer the horizon of the guidance, implying that it may be
difficult to provide much more stimulus through this channel. As for our
balance sheet operations, although we have now acquired some experience
with this tool, there is still considerable uncertainty about its likely
economic effects. Moreover, some have expressed concern that a
substantial further expansion of the balance sheet could interfere with
the Fedfs ability to execute a smooth exit from its accommodative
policies at the appropriate time. I disagree with this view: The FOMC
has tested a variety of tools to ensure that we will be able to raise
short-term interest rates when needed while gradually returning the
portfolio to a more normal size and composition. But even if
unjustified, such concerns could in theory reduce confidence in the
Federal Reserve and so lead to an undesired increase in inflation
expectations.
On the other hand, risk management considerations arising from
todayfs unusual circumstances strengthen the case for additional
accommodation beyond that called for by simple policy rules and optimal
control under the modal outlook. In particular, as I have noted, there
are a number of significant downside risks to the economic outlook, and
hence it may well be appropriate to insure against adverse shocks that
could push the economy into territory where a self-reinforcing downward
spiral of economic weakness would be difficult to arrest.
Conclusion
In my remarks this evening I have sought to explain why, in my
view, a highly accommodative monetary policy will remain appropriate for
some time to come. My views concerning the stance of monetary policy
reflect the FOMCfs firm commitment to the goals of maximum employment
and stable prices, my appraisal of the medium term outlook (which is
importantly shaped by the persistent legacy of the housing bust and
ensuing financial crisis), and by my assessment of the balance of risks
facing the economy. Of course, as Ifve emphasized, the outlook is
uncertain and the Committee will need to adjust policy as appropriate as
actual conditions unfold. For this reason, the FOMCfs forward guidance
is explicitly conditioned on its anticipation of glow rates of resource
utilization and a subdued outlook for inflation over the medium run.h23
If the recovery were to proceed faster than expected or if inflation
pressures were to pick up materially, the FOMC could adjust policy by
bringing forward the expected date of tightening. In contrast, if the
Committee judges that the recovery is proceeding at an insufficient
pace, we could undertake portfolio actions such as additional asset
purchases or a further maturity extension program. It is for this reason
that the FOMC emphasized, in its statement following the April meeting,
that it would “regularly review the size and composition of its
securities holdings and is prepared to adjust those holdings as
appropriate to promote a stronger economic recovery in a context of
price stability.”
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** MNI **
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