A Historical Analysis of Monetary Policy Rules

If a monetary rule is used to set policy, the rule chosen should dictate relatively aggressive adjustments of the short-term interest rate in response to changes in inflation and real output.

The recent decline in inflation in major industrial countries has led to a general reassessment of just what constitutes effective monetary policy. Government officials around the world are asking: should central banks respond to events on a case by case basis, better known as using discretionary policy? Or, should they agree in advance on how policy instruments will be used to respond to economic changes, known as adopting a monetary rule?

In An Historical Analysis of Monetary Policy Rules (NBER Working Paper No. 6768) , NBER Research Associate John Taylor analyzes a century of U.S. monetary history with a simple monetary policy rule as a "yardstick." The rule specifies how officials should adjust the short-term interest rate in response to changes in inflation-adjusted GDP and the inflation rate. Taylor concludes that if a monetary rule is used to set policy, the rule chosen should dictate relatively aggressive adjustments of the short-term interest rate in response to changes in inflation and real output. In fact, responsive short-term interest rates may help flatten economic fluctuations, he believes. After examining the responsiveness of short-term rate from 1879 to the present, Taylor concludes that the "dramatic" changes in U.S. monetary policy over the last 125 years have been associated with "equally dramatic changes in economic stability." The changes in monetary policy are best described as "the result of an evolutionary learning process in which the Federal Reserve--from the day it began operations in 1914 to today--has searched for" a good procedure for adjusting the instruments of policy.

From 1879 to 1914, the United States was on the international gold standard, a regime that put an external constraint on long-run inflation. Short-term interest rates were relatively unresponsive to changes in output and inflation during this period, and recessions were both frequent and severe. The Federal Reserve System was founded in 1914, just as the classical gold standard was ending at the start of World War I. The Fed, as the lender of last resort, clearly was supposed to provide money as necessary, but there was no agreement either on how quickly it should react to economic change or on how much money it should supply. According to Taylor, "that the Fed was unable throughout the interwar period to find an effective policy rule for conducting monetary policy is evidenced by the disastrous economic performance during the Great Depression when money growth fell dramatically."

After a monetary policy hiatus during World War II, when the overriding objective was to minimize the Treasury's borrowing costs, the Fed resumed its search for an appropriate way to conduct monetary policy. During the 1960-1 recession, short-term rates were kept relatively high, and recovery was slow. When the Bretton Woods system failed in the early 1970s, the last external constraint on inflation disappeared. Policymakers, concerned with maintaining low short-term interest rates, were reluctant to prevent accelerating rates of inflation. The result was the Great Inflation of the 1970s, and its 1982-4 aftermath, in which everyone learned painful lessons about the high costs of inflation.

The 1980s and the 1990s have been a time of much more stable inflation and relatively mild economic fluctuations. Comparing the results of a simple monetary policy rule with the actual changes in the Federal funds rate during this period shows that interest rates were within the range dictated by Taylor's simple monetary policy rule. Rates were outside this range during the periods when there was much less stability, including the period of the international gold standard and the period of the Great Inflation in the late 1960s and 1970s. In both periods, short-term interest rates responded too little and too late to changes in inflation and real output.

-- Linda Gorman