David Papell on the History, Motivations, and Current Applications of Monetary Policy Rules

Episode Summary

Executive Summary: The episode traces the history and logic of monetary policy rules, especially the Taylor rule, and applies them to the post-COVID Fed. David Pappell argues rules are best used as benchmarks, not rigid mandates, and that real-time data show the Fed fell behind the curve in 2021. His updated paper finds current policy is roughly aligned with rule prescriptions, while future cuts may diverge depending on whether the Fed follows inertial or non-inertial adjustments.

Main Topics: Origins of monetary policy rules: The conversation begins with Friedman’s k-percent rule and the transition toward activist, feedback-based rules from McCallum and Taylor. The Taylor rule’s use of the federal funds rate made it more relevant to actual Fed practice. Why rules matter: time inconsistency and accountability: Rules are motivated by time inconsistency, transparency, and the need for a benchmark that helps the public and policymakers assess deviations and explain policy choices. Taylor rule mechanics and the Taylor principle: The Taylor principle requires raising nominal rates more than one-for-one with inflation so real rates rise. The rule’s key terms are the equilibrium real rate, inflation gap, and output gap. Rule variants: balanced approach, shortfall, and inertial rules: The discussion explains how the balanced approach places more weight on slack, how shortfall rules reflect the Fed’s FAIT framework, and how inertial rules model gradual rate adjustments. Real-time data and the Orphanides debate: Pappell discusses how real-time output-gap measures matter for evaluating past Fed policy, arguing that revisions and contemporaneous perceptions can materially change conclusions about the 1970s. Post-COVID application of policy rules: Pappell’s paper compares 12 rule variants using real-time data and SEP forecasts from 2020 onward, finding the Fed was behind the curve in 2021 but is now close to rule-based prescriptions. Implications for the FOMC and forward guidance: The episode closes with advice that the Fed should use rules as a benchmark, especially in real time, to reduce policy volatility and justify deviations when they occur.

Key Arguments: Policy rules are benchmarks for accountability and communication, not rigid formulas the Fed must follow exactly. The Taylor rule became influential because it matched the Fed’s interest-rate instrument and produced a striking empirical fit in the early 1990s. The Taylor principle is essential: inflation control requires real rates to rise, not merely keep pace with inflation. The balanced approach rule gained traction after the Great Recession partly because it better accommodated the zero lower bound and quantitative easing. The Fed’s FAIT framework requires modifying Taylor-style rules to include inflation shortfalls and unemployment shortfalls rather than symmetric gaps. Real-time data are crucial; evaluating policy with revised data can distort judgments about whether the Fed was truly following or deviating from a rule. Using the Fed’s own data and forecasts, the 2021 policy stance was too easy, and by September 2021 the Fed was already behind the curve. Non-inertial rules imply much larger and faster moves than the Fed is likely to make, but inertial rules closely track actual policy in the recent hiking cycle. Going forward, market pricing may align more with non-inertial easing than the Fed’s own inertial path, especially if cuts begin sooner than current SEP projections suggest. Large structural deficits could raise the equilibrium real rate over time, so r-star should not be treated as permanently fixed at 0.5%.

Data Points: K-percent rule: Constant money-supply growth - Friedman’s non-activist monetary policy rule Original Taylor rule output-gap coefficient: 0.5 - 1993 Taylor rule weight on the output gap Balanced approach output-gap coefficient: 1.0 - Taylor’s 1999 balanced approach rule doubles the output-gap response Taylor rule equilibrium real rate (r): 2.0% - Original Taylor 1993 calibration based on prior long-run growth Fed/SEP long-run r estimate: 0.5% - Fed projections used in Pappell’s updated paper before and after COVID Inflation target: 2% - Fed’s longer-run inflation projection and Taylor-rule target Annual core PCE inflation, March 2021: About 1.5% - Used to show the Fed still faced subdued inflation in early 2021 Annual core PCE inflation, June 2021: About 3.5% - Shows the sharp rise in inflation as the Fed remained accommodative Fed 2021 median core PCE forecast: 2% to 3% - SEP forecasts shifted up quickly as inflation pressures intensified Unemployment threshold for shortfall rules: Below 4% - Shortfall rules differ from traditional rules only once unemployment falls below this level CEA output gap in 1975: -16.2% - Orphanides-style real-time measure cited as overly large Alternative 1975 output-gap perception: About -9.9% - Based on Brookings/Okun’s-law style contemporaneous perceptions Linear detrended output gap, 1975: About -10.4% - Pappell’s comparison showing a middle ground between revised and CEA data Quadratic detrended output gap, 1975: About -10.8% - Another contemporaneous-style estimate closer to perceived slack Non-inertial rule gap by March 2022: About 800 basis points too low - Illustrates how unrealistic immediate adjustment would have been after the inflation surge Inertial rule gap by March 2022: About 200 basis points - Shows more plausible policy adjustment under gradualism Fed hikes by late 2023: Approximately 25 bps above the prescribed rule under some projections - Pappell notes current policy is near rule prescriptions depending on the scenario SEP horizon: Through December 2026 - Pappell updates the analysis with FOMC projections through the end of 2026 Initial liftoff timing range from rules: March 2021 to June 2023 - Different rule variants implied very different exit dates from the effective lower bound

Pivotal Quotes: "Nobody has ever advocated following a policy rule, exactly, except for people who are opposed to policy rules." — David Pappell: Explaining that rules are benchmarks used to guide and evaluate policy, not strict mechanical commands "The idea of the Taylor principle is that when inflation goes up, you want to raise the federal funds rate... more than point for point so that the real interest rate goes up." — David Pappell: Defining the core stabilization logic behind the Taylor rule "When Fed officials say, well, if we had known this at the time, we would have acted differently, my response was, you did know this at the time, and you didn't act." — David Pappell: Arguing that real-time data and forecasts already showed the Fed was behind the curve in 2021

Implications: For listeners and policymakers, the key lesson is that rule-based benchmarks can improve transparency, discipline, and communication. The Fed should compare its actions to rules in real time, explain deviations clearly, and avoid repeating the delayed response of 2021.