The Yellen Rules The Yellen Rules Alex Nikolsko-Rzhevskyy Lehigh University David Papell and Ruxandra Prodan University of Houston Monetary Rules for a Post-Crisis World Mercatus-CMFA Academic Conference, September 7, 2016 Nikolsko-Rzhevskyy, Papell, Prodan 1 The Yellen Rules Policy Rule Legislation Proposed by John Taylor in 2011 Cato Journal By the End of 2015 Legislation Passed House Financial Services Committee Senate Banking Committee House of Representatives

The Fed Chooses the Rule Fed is Not Forced to Adopt the Taylor (1993) Rule Nikolsko-Rzhevskyy, Papell, Prodan 2 The Yellen Rules Policy Rule Legislation Suppose the Fed Were to Adopt a Policy Rule Legislated To Preclude Legislation Fed Preference for a Policy Rule What Rule Should the Fed Adopt? Three Criteria Consistency with Long-Term Economic Performance Consistency with Fed Policy Following the Great Recession Consistency with Projected Fed Policy

First Criteria Normative - Second and Third Pragmatic Nikolsko-Rzhevskyy, Papell, Prodan 3 The Yellen Rules Taylor Rules Balanced it = pt + 0.5 (pt 2.0) + 0.5 yt + R* R* = 2 in Taylor (1993) R* = Laubach and Williams R*t in Yellen (2015) Output Gap Tilting it = pt + 0.5 (pt 2.0) + 1.0 yt + R* R* = 2 in Yellen (2012) Inflation Gap Tilting it = pt + 1.0 (pt 2.0) + 0.5 yt +R*

Nikolsko-Rzhevskyy, Papell, Prodan 4 The Yellen Rules Real-Time Data Inflation GDP/GNP Deflator for 1965 - 2015 Core PCE for 2009 - 2016 Output Gap Quadratic Detrended Real GDP/GNP for 1965 - 2015 CBO for 2009 - 2016 Policy Rate Federal Funds Rate for 1965 2008 and 2016 Shadow FFR from Wu and Xia (2016) for 2009 - 2015 Nikolsko-Rzhevskyy, Papell, Prodan 5

The Yellen Rules Real-Time Data Equilibrium Real Interest Rate Two Trend Growth for Previous 10 Years Laubach and Williams (2003) Real-Time Since 2005 Holston, Laubach and Williams (2016) Real-Time Since 2005 Nikolsko-Rzhevskyy, Papell, Prodan 6 The Yellen Rules Consistency with Long-Term Economic Performance Policy Rules and Economic Performance Nikolsko-Rzhevskyy, Papell, and Prodan (2016) Policy Rule Deviations Prescribed FFR Actual FFR

Rules-Based or Discretionary if Small or Large Quadratic Loss Functions Loss = S ((p p*)2 + (U U*)2) Quadratic Loss Ratios Ratio of Loss in Discretionary and Rules-Based Periods Good Policy Rules have Large Loss Ratios Nikolsko-Rzhevskyy, Papell, Prodan 7 The Yellen Rules Deviations from the Original Taylor Rule Nikolsko-Rzhevskyy, Papell, Prodan 8

The Yellen Rules Discretion to Rules Loss Ratios 100 Taylor Rules Coefficients on Inflation and Output Gaps Between 0.1 and 1.0 Increments of 0.1 Benchmark Equal Weights on Inflation and Unemployment Loss p* = R* = 2 Threshold for Deviations = 2.0 Policy Lag of 6 Quarters Change Weights, R*, Threshold, and Lags Nikolsko-Rzhevskyy, Papell, Prodan 9 The Yellen Rules Discretion to Rules Loss Ratios 1:1 Weights, Threshold=2%, R*=2% and p*=2%, 6-Quarter Lag

Nikolsko-Rzhevskyy, Papell, Prodan 10 The Yellen Rules Quintiles of the Quadratic Loss Ratios for Policy Rules Inflation Gap Tilting Rule ( Balanced Rule ( Output Gap Tilting Rule ( R* = 2 1 2 4 R* = Trend Growth

1 3 4 R* = LW 1 3 5 R* = HLW 1 3 5 Nikolsko-Rzhevskyy, Papell, Prodan 11 The Yellen Rules Consistency with Long-Term Economic Performance

Strong Preference for Inflation Gap Tilting Rules Result Generalizes Beyond These 12 Rules Robust to Many Variations Laubach and Williams (2016) Value of R* Affects Intercept of Taylor Rule Point-for-Point Estimates of R* Very Uncertain Advocate Strong Response to Inflation Decrease Importance of Estimating R* Correctly Consistent with Our Results Nikolsko-Rzhevskyy, Papell, Prodan 12 The Yellen Rules Consistency with Fed Policy Following the Great Recession Pragmatic Rather than Normative Fed Wont Adopt Rule that is Inconsistent with Recent Policy

Average Deviations Absolute Value of Deviations Similar Deviations Based on Current Data Policy Continuity Nikolsko-Rzhevskyy, Papell, Prodan 13 The Yellen Rules Balanced Rules ( Nikolsko-Rzhevskyy, Papell, Prodan 14 The Yellen Rules Output Gap Tilting Rules ( Nikolsko-Rzhevskyy, Papell, Prodan 15 The Yellen Rules

Inflation Gap Tilting Rules ( Nikolsko-Rzhevskyy, Papell, Prodan 16 The Yellen Rules Average Deviations and Last Quarter Deviation for All Rules Inflation Gap Tilting Rule ( Avg. deviations Balanced Rule ( Output Gap Tilting Rule ( Last quarter Last quarter Avg. Avg. deviation deviations deviation deviations 1.76 1.58

1.74 -0.75 Last quarter deviation 0.43 R* = 2 1.44 R* = Trend Growth 0.94 0.83 1.24 1.01 -1.26 -0.32 R* = LW -0.37

-0.24 -0.08 -0.06 -2.57 -1.39 R* = HLW 0.08 -0.15 0.38 0.03 -2.12 -1.30 Nikolsko-Rzhevskyy, Papell, Prodan 17 The Yellen Rules

Consistency with Projected Fed Policy Compare Prescribed and Projected Federal Funds Rate Pragmatic Rather than Normative Federal Funds Rate and Core PCE Projections from SEP Median Projections for End of 2016, 2017, 2018 and Longer Run FOMC Meetings for December 2015, March 2016, and June 2016 Output Gap Projections from CBO Includes August 2016 Update CBO Projects Zero Output Gap Starting End of 2016 Taylor (1993) and Yellen (2012) Rule Projections Identical Nikolsko-Rzhevskyy, Papell, Prodan 18 The Yellen Rules Taylor (1993) and Yellen (2012) Rules Prescribed and Projected FFR

December 2015 SEP March 2016 SEP June 2016 SEP Prescribed FFR Projected FFR Prescribed FFR Projected FFR Prescribed FFR Projected FFR 2016 3.4% 1.4%

3.4% 0.9% 3.6% 0.9% 2017 3.8% 2.4% 3.7% 1.9% 3.9% 1.6% 2018 4.0% 3.3% 4.0%

3.0% 4.0% 2.4% Longer Run 4.0% 4.0% 4.0% 3.3% 4.0% 3.0% Nikolsko-Rzhevskyy, Papell, Prodan 19 The Yellen Rules Consistency with Projected Fed Policy

Yellen (2015) Rule Uses Laubach and Williams R* Cant Compute R* Projections from SEP and CBO Data Cant Compare Prescribed and Projected FFR Calculate Projected R* Conditional of Projected FFR Laubach and Williams R* 0.19 in 2016:Q1 0.18 in 2016:Q2 Nikolsko-Rzhevskyy, Papell, Prodan 20 The Yellen Rules Yellen (2015) Rule R* Conditional On Projected FFR December 2015 SEP March 2016 SEP June 2016 SEP

Balanced Inflation Gap Tilting Balanced Inflation Gap Tilting Balanced Inflation Gap Tilting 2016 0.0% 0.2% -0.5% -0.3% -0.7% -0.5% 2017

0.6% 0.6% 0.2% 0.3% -0.3% -0.2% 2018 1.3% 1.3% 1.0% 1.0% 0.4% 0.4% Longer Run

1.5% 1.5% 1.3% 1.3% 1.0% 1.0% Nikolsko-Rzhevskyy, Papell, Prodan 21 The Yellen Rules Yellen (2016) Rule from Jackson Hole Symposium Taylor Rule with an Unemployment Gap it = R* + pt + 0.5(pt p*) 2.0(Ut U*) R* = 1%, U* = 4.8 %, p is Core PCE, and p* = 2 Coefficient of -2.0 Consistent with 1.0 on Output Gap Okuns Law Coefficient = 2

Unemployment Gap Tilting Policy Rule Yellen (2016) and Reifschneider (2016) Consistent with FOMC Behavior from 2000 - 2008 Nikolsko-Rzhevskyy, Papell, Prodan 22 The Yellen Rules Consistency with Long-Term Economic Performance Same Methodology as for Output Gap Rules No Long-Term Real-Time Data for U* Robert Gordons Text (Various Editions) for 1965 2008 SEP Projections for 2009 2016 No Long-Term Real-Time Data for PCE Inflation Use GDP/GNP Inflation Calculate Quadratic Loss Ratios for 100 Policy Rules Yellen (2016) Rule is in the Fourth Quintile Output Gap Version with R* = 1 is in the Fifth Quintile

Yellen (2016) Rule Not Consistent with First Criterion Nikolsko-Rzhevskyy, Papell, Prodan 23 The Yellen Rules Consistency with Fed Policy Following the Great Recession Average Deviation = -2.41 Percent Second Highest Among the 13 Rules Current Deviation = 1.89 Percent Largest Among the 13 Rules Yellen (2016) Rule Not Consistent with Second Criterion Nikolsko-Rzhevskyy, Papell, Prodan 24

The Yellen Rules Yellen (2016) Rule Nikolsko-Rzhevskyy, Papell, Prodan 25 The Yellen Rules Consistency with Projected Fed Policy Projected Path of the Federal Funds Rate Core PCE and Unemployment Projections from June SEP Projected Federal Funds Rate 2.75 Percent at End of 2016 3.25 Percent at End of 2017 3.4 Percent at End of 2019 3.0 Percent in Longer Run Very Different than Path of Fed Projections

Yellen (2016) Rule Not Consistent with Third Criterion Nikolsko-Rzhevskyy, Papell, Prodan 26 The Yellen Rules Conclusions Propose Three Criteria for a Fed Policy Rule Consistency with Long-Term Economic Performance Consistency with Fed Policy Following the Great Recession Consistency with Projected Fed Policy Inflation Gap Tilting Version of Yellen (2015) Rule Higher Coefficient on Inflation Gap than on Output Gap LW Time Varying Equilibrium Real Interest Rate Only Rule Consistent with All Three Criteria Close Correspondence with Dec 2015 SEP

Yellen (2016) Rule Not Consistent with Any Criterion Nikolsko-Rzhevskyy, Papell, Prodan 27