Comments and Discussion

Jonathan A. Parker:

Athanasios Orphanides and John Williams have written an ambitious paper that tackles a difficult and important question: how should a central bank conduct monetary policy in practice, that is, not in a simple model of the economy, but in the complex and shifting U.S. economy? The authors focus on two related problems that the Federal Reserve confronts continuously in its attempts to stabilize economic growth.

First, there is a great deal of uncertainty at any point in time about the true state of the economy, and actual policy can be based only on information available at the time. A week before this conference, at the annual symposium on monetary policy in Jackson Hole, Wyoming, Federal Reserve Chairman Alan Greenspan spoke about the difficulty the Federal Reserve had encountered in guiding the economy through the boom of the late 1990s:

The struggle to understand developments in the economy and financial markets since the mid-1990s has been particularly challenging for monetary policymakers. We were confronted with forces that none of us had personally experienced . . . . As events evolved, we recognized that, despite our suspicions, it was very difficult to definitively identify a bubble until after the fact.¹

There is even now considerable uncertainty as to whether the increase in asset prices of the late 1990s was a bubble, which tighter monetary policy should have reined in, or an optimal response to changed economic conditions, such as the possibility that the United States was in a technological revolution that would increase the rate of growth of trend productivity. If one bases policy on poor estimates of the current state of the economy, estimation error becomes policy error. Stabilization policy becomes destabilizing.

The second main problem that confronts policymakers is uncertainty about the response of the economy to the policies that they consider. In his speech at Jackson Hole, Greenspan went on to argue that "it was far from obvious that bubbles, even if identified early, could be preempted short of the central bank inducing a substantial contraction in economic activity—the very outcome we would be seeking to avoid." Thus the Federal Open Market Committee did not act to reduce equity prices in part because committee members were unsure whether those prices were or were not justified by the fundamentals, and in part because they were unsure whether they could reduce equity prices, or at least slow the increase in prices, without slowing the economy so much as to cause a recession. Of course, we now know that a recession was not avoided. Following the turnaround in the stock market, a recession began in March 2001 and probably ended late that year. This second source of uncertainty poses the following question for policy: even supposing that the data during the 1990s had been clear, would and should a more contractionary policy have smoothed out some of the observed boom and recession? If one sets interest rates according to policies that are optimal in a model that turns out to be a poor approximation of the real world, model error becomes policy error. And again, stabilization policy becomes destabilizing.

Given these problems, Orphanides and Williams recommend using a policy rule that sets the federal funds rate, f_t, as follows:

in which the parameters (the θ's) on the inflation gap and the change in the unemployment rate are chosen so as to allow for substantial movement in the natural rate of interest and the natural rate of unemployment. The authors base this recommendation on their finding that this rule performs well in the sense of achieving close to the minimal attainable value of the following loss function:

for a set of three simple models of the U.S. economy.

This rule deals with the first problem—that the Federal Reserve does not know the true state of the economy—because it does not depend on real-time estimates of the natural rate of interest or the full-employment level of unemployment. Rather, this rule depends only on economic variables that are observed easily and (almost) contemporaneously with their occurrence. As an example of...