IV. A Guide to Central Bank Interest Rates: The Taylor Rule
A. A simple formula approximates what the FOMC does, tracking the behavior of the target
federal funds rate and relating it to the real interest rate, inflation, and output.
B. The formula is: Target Fed Funds rate = 2 + current inflation + ½ (inflation gap) + ½
(output gap)
C. The 2 term is the assumed long-term real interest rate. The inflation gap is current
inflation minus an inflation target, and the output gap is current GDP minus its potential
level.
D. When inflation rises about its target level, the response is to raise interest rates; when
output falls below the target level, the response is to lower interest rates.
E. One interesting property of the Taylor Rule is that increases in inflation raise the real
interest rate.
F. The “½” terms in the equation depend on how sensitive the economy is to interest rate
changes and on the preferences of central bankers.
G. Some caveats: the Taylor Rule is too simple to take into account sudden threats to
financial stability. Also, the lack of real-time data limits its usefulness in ongoing policy
making.
H. When the financial conditions are much stronger or much weaker than usual, policy
makers may set an interest rate target substantially different than the Taylor Rule.
I. Financial conditions affect policy choices because they alter prospects for private
spending and for inflation.
V. Unconventional Policy Tools
A. There are two circumstances when additional policy tools can play a useful stabilization
role:
A. When lowering the target interest rate to zero is not sufficient to stimulate the
economy
B. When an impaired financial system prevents conventional interest rate policy from
supporting the economy
B. Monetary policy can be effective even when the target rate is zero.
1. The Fed still has powerful tools at their disposal, but these tools are less predictable,
more complicated to determine, and difficult to exit from.
C. Three categories of unconventional policies exist: forward guidance, quantitative easing,
and targeted asset purchases.
1. Forward guidance communicates a central bank’s intentions regarding the future path
of monetary policy.
a. Forward guidance is guidance today about policy target rates in the future. It can
have a specific termination date, or its duration could be dependent on future
changes in economic conditions.
b. Forward guidance lowers long-term interest rates that affect private spending.
c. Forward guidance must be credible.
2. Quantitative easing occurs when the central bank expands the supply of aggregate
reserves to the banking system beyond the level that would be needed to maintain its
policy rate target. The central bank uses the proceeds from the reserve expansion to
buy assets, expanding its balance sheet.
a. It is difficult to predict the effects of QE and the mechanisms by which QE affects
economic prospects is not clear.
b. QE can add credibility to a policymaker’s promise to keep interest rates low,
supporting the impact of a policy duration commitment.
c. QE’s key problem is that central banks do not know how much is needed to be
effective.
3. Targeted asset purchases shifts the composition of the balance sheet toward selected
assets in order to boost their relative price and stimulate economic activity.
a. TAP can influence both the cost and availability of credit, increasing the demand
for an asset and raising its price.
b. The impact of TAP is likely to be greater in an illiquid market.
c. Problems with TAP include that it is difficult for central bankers to use because
the central bank cannot reliably anticipate the impact of TAP on the cost of credit.
D. The introduction of unconventional policies requires considering future actions. These
actions can be difficult to exit from as exiting can create instability.
E. During the financial crisis of 2007-2009 the Fed raised its deposit rate from 0 to a new,
positive rate. This allowed the Fed to increase or decrease the level of reserves without
changing the reserve ratio, adjust the target rate for interbank loans without changing the
size or composition of its balance sheet, and adjust the size and composition of its
balance sheet without changing the target rate for interbank loans.
Terms Introduced in Chapter 18
conventional policy tools
deposit rate
discount lending
discount rate
ECB’s Deposit Facility
ECB’s Marginal Lending Facility
forward guidance
inflation targeting
intermediate targets
lender of last resort
market federal funds rate
minimum bid rate
overnight cash rate
primary credit
primary discount rate
quantitative easing
repurchase agreement (repo)
reserve requirement
secondary discount rate
target federal funds rate
targeted asset purchases
Taylor rule
unconventional policy tools
zero bound
Using FRED: Codes for Data in This Chapter
Data Series FRED Data Code
FRB assets WALCL
MBS WSHOMCB
Treasuries WSHOTS
Agencies WSHOFDSL
Repos WARAL
Loans WALLNL
Federal funds rate FEDFUNDS
Discount rate WPCREDIT
Interest paid on required reserves INTREQ1
Required reserves REQRESNS
Excess reserves EXCRESNS
Primary credit WPC
Potential GDP GDPPOT
Real GDP GDPC1
Personal consumption expenditures price index PCEPI
Lessons of Chapter 18
1. The Federal Reserve has four conventional monetary policy tools.
a. The target federal funds rate is the primary instrument of monetary policy.
i. Open market operations are used to control the federal funds rate.
ii. The Fed forecasts the demand for reserves each day and then supplies the amount
needed to meet the demand at the target rate.
b. The discount lending rate is used to supply funds to banks, particularly during crises.
ii. The Fed sets the primary lending rate at a spread above the target federal funds rate.
iii. In setting the primary lending rate above the target federal funds rate, the Fed is
attempting to stabilize the market interest rate on overnight interbank lending. The
primary lending rate is the cap for the market rate on overnight interbank loans.
iii. The Fed also makes loans to banks in distress and to banks in need of seasonal
liquidity.
c. The deposit rate is the rate that the Fed pays on excess reserves held by banks at the
central bank.
iii. The deposit rate is set at a spread below the target federal funds rate.
iv. The deposit rate determines the floor for the market rate on overnight interbank loans.
d. Reserve requirements are used to stabilize the demand for reserves.
iv. Banks are required to hold reserves against certain deposits.
v. Banks can hold either deposits at Federal Reserve Banks that earn interest or vault
cash.
iv. Reserves are accounted for in such a way that everyone knows the level of reserves
required several weeks before banks must hold them.
2. The European Central Bank’s primary objective is price stability.
a. The ECB provides liquidity to the banking system through weekly auctions called
refinancing operations.
b. The minimum bid rate on the main refinancing operations, also known as the target
refinancing rate, is the target interest rate controlled by the Governing Council.
c. The ECB allows banks to borrow from the marginal lending facility at an interest rate that
is set above the target refinancing rate.
d. Banks with excess reserves can deposit them at national central banks and receive interest
at a spread below the target refinancing rate.
e. European banks are required to hold reserves; they receive an interest rate on their
balances that is equal to the average of the rate in recent refinancing operations.
3. Monetary policymakers use several tools to meet their objectives.
a. The best tools are observable, controllable, and tightly linked to objectives.
b. Short-term interest rates are the primary tools for monetary policymaking.
c. Modern central banks do not use intermediate targets like money growth.
4. The Taylor rule is a simple equation that describes movements in the federal funds target rate.
It suggests that
a. When inflation rises, the FOMC raises the target interest rate by 1½ times the increase.
b. When output rises above potential by 1 percent, the FOMC raises the target interest rate
half a percentage point.
5. Unconventional monetary policy can supplement conventional policy when a zero policy rate
is not low enough to stabilize the economy or when an impaired financial system prevents
conventional interest-rate policy from working. The three principal unconventional tools of the
central bank are:
a. Forward Guidance: promising to keep rates low in the future.
b. Quantitative easing: supplying aggregate reserves beyond the quantity needed to lower
the policy rate to zero.
c. Targeted asset purchases: changing the mix of assets at the central bank to alter their
relative prices.
6. Unconventional monetary policy is unpredictable and potentially disruptive, so it is used only
in those extraordinary circumstances when the conventional toolkit is insufficient to stabilize the
economy. One conventional policy tool—the payment of interest on reserves—can help a central
bank exit smoothly from unconventional monetary policy.