The FOMC’s Policy Reaction Function: Two Interpretations

I consider two interpretations of the FOMC’s policy rule and compare these to the previously dominant balanced approach rule. The first specification is the one I offered earlier. In the past, Chair Yellen used participants’ median estimates of r-star and the NAIRU and the parameters on the inflation and unemployment rates from her earlier balanced approach rule. But different participants have different interpretations of the rule. The Powell Fed’s behavior has differed. One explanation is that r-star may be lower—though ½ percent  (in real terms) seems to be a lower bound. But, more importantly, some believe the NAIRU is lower. That also explains why the policy has not tightened to a greater degree in response to a decline in the unemployment rate well beyond the estimated NAIRU. 

The Balanced Approach Rule I and II 

Recall that Yellen offered two specifications of a policy rule: one for normal times and one for during and after the Great Recession when there were unprecedented headwinds weighing on the economy.1In that case, prescriptions from the rule must be adjusted downward to reflect the fact that r-star is lower than its longer-run level. 

The Balanced Approach Rule in Normal Times 

Here is the balanced approach rule offered in 2012, appropriate in normal times: 

Policymakers emphasized that the most important feature of the balanced approach rule was the large size of the parameter on the unemployment gap, the aggressive response to deviations from full employment. I use this as a point of departure because this rule remains a mainstay at the Fed and is one the Board staff features in its semiannual Monetary Policy Report.  

Yellen and other policymakers used the rule to explain why ZIRP had been favored for such a long time and continued to be. One reason was that the rule prescribed a funds rate well below zero, a level of accommodation the FOMC was unable to deliver. That suggested the FOMC should compensate via other means, such as QE, and keeping the fund’s rate lower for longer. Another reason to deviate from a rule from normal times was that the FOMC had to offset unprecedented headwinds, leading them to keep rates lower for longer than otherwise. They introduced a lower short-term r-star—relevant for policy decisions at the  

1 Yellen discussed this rule in Janet L. Yellen’s (2012), “The Economic Outlook and Monetary Policy,” speech delivered at the Money Marketeers of New York University, New York, April 11. 

2 This is the balanced approach rule as shown in the Monetary Policy Report. 

time—while retaining the higher one for normal times. R-star was supposed to converge to its longer-run level as the headwinds dissipated. That didn’t happen, but that’s another story. 

Today’s FOMC Policy Rule I: Flat-Phillips-Curve Version 

One possible way of interpreting FOMC policy today in terms of policy rules is to say that the FOMC has sharply down-weighted the parameter on the unemployment gap. Once the unemployment rate reached the median estimate of the NAIRU, the FOMC simply has not moved the fund’s rate in response to declines in the unemployment rate, which has declined to a level way below the NAIRU. I speculate that such a  down weighting of the u-gap is appropriate based on the very low sensitivity of inflation to the u-gap. In that case, the FOMC should not respond aggressively to movement in it. 

Today’s FOMC Policy Rule II: Low-NAIRU Version 

An alternative, and equally reasonable, interpretation of today’s policy rule is to say that the NAIRU has fallen so low that there is no unemployment rate gap today. In that case, the fund’s rate should be at its neutral rate. Today, the fund’s rate is at the lower edge of the broad range of estimates of neutral; as I like to say,  good enough for government work, as long as that assumption is not disconfirmed by the inflation rate.  

For some time I’ve believed that FOMC participants’ median NAIRU estimated likely overstated how high many on the FOMC suspect it really is. The further one-tenth decline in the NAIRU in the March projections,  following a previous one-tenth decline in December, is consistent with that view.  

My View 

I am more sympathetic to the Flat-Phillips-Curve Policy Rule, though only a shade more so than the Low NAIRU Policy rule. Whatever the case, the two camps are comfortable with the current policy rate. The sharp downward revision to the March dots brought the median projected path of the fund’s rate much of the way toward a consensus for no more rate hikes through the forecast horizon.

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