William Poole -- University of Chicago, Ph.D., 1966 -- President and CEO, Federal Reserve Bank of St. Louis, --Understanding Inflation

The rational expectations literature makes clear that policy regimes are the correct way to interpret policy. Tom Sargent has defined a regime as “a function or rule for repeatedly selecting settings for economic policy variables as a function of the state of the economy.”(5) Others have labeled this “rule-like behavior.” A policy regime, in some cases, might be as simple as a single equation; an example is the Taylor Rule, which I and many others have discussed elsewhere. In this case, the policy rule, rather than federal funds rate, is the instrument of monetary policy—the federal funds target is an endogenous variable within the larger model. The precise form of the rule, so long as it is consistent with price stability, is less important than policymakers displaying rule-like behavior. The “rule” certainly need not be a simple linear equation. Rather, the rule is a method of decision-making and a commitment to a specific, articulated objective. Nobel laureate Robert Lucas (1981) credits the introduction of this concept to Milton Friedman in his 1948 “A Monetary and Fiscal Framework for Economic Stability.”(6) In the same article, Lucas notes that Friedman’s maxim was lost to policymakers during the two decades of prosperity that followed the 1948 Employment Act, setting the stage for the Great Inflation.

Actual policymaking, of course, requires large doses of experience and judgment—former Chairman Alan Greenspan argued that model uncertainty counseled caution in policymaking. Models omit many real-world problems such as incomplete and asymmetric information, the high cost of information and the value to both workers and firms of multi-period contracts. Nevertheless, the essential insight of rational expectations survives—a sound policy rule or regime is essential for a good outcome.

Some analysts have argued against rules for monetary policymaking, viewing them as straitjackets for policy. If policymakers adopt a model, how do they respond when the economy changes significantly? Modern models clarify that the benefits of “rule-like” behavior accrue even if the central bank from time to time changes its policy regime or rule.(7) What is required is that at each instance when policymakers decide to take an action that is not consistent with their extant rule, the new action must be consistent with some policy rule that, in the medium- to long-term, will achieve the stated policy objective. Surely it cannot be the case that an optimal policy response to a new set of circumstances could be determined by consulting a table of random numbers.

When policy departs from usual practice, it is incumbent that policymakers communicate the change—its nature and rationale—carefully to the public. Monetary policy is more powerful, and better able to achieve its goals, if the forward-looking behavior of consumers and businesses is consistent with the forward-looking behavior suggested by the policy rule or regime. For several years, I have referred to this as “synching” the markets and monetary policy. The fundamental mechanism for making synching work is communicating the policy regime or rule—but rule-like behavior must be adopted by policymakers in the first place before it can be communicated to the public.