Since mid-September, when former U.S. Treasury Secretary Larry Summers withdrew his name from consideration to replace Ben Bernanke as chairman of the Federal Reserve next year, market participants have become increasingly interested in the policy views of current Fed vice-chair Janet Yellen, who is now set to take the reins at the central bank when Bernanke’s term expires in January.
One item in particular has become the center of attention for those trying to figure out how a Yellen Fed will be different: the “optimal control” approach to monetary policymaking, as outlined by Yellen in a series of speeches last year.
Michael Feroli, chief U.S. economist at JPMorgan, sums up the idea succinctly in a recent report: “This approach starts with a forecast for the economy, and then solves a large-scale macroeconomic model to find the path of the funds rate that minimizes the deviation of inflation and unemployment from their respective targets.”
After some rigmarole it gets to the great part:
Optimal control policies are not, per se, a Yellen innovation. At each FOMC meeting the Fed staff prepares the “Bluebook,” which presents various policy alternatives. Since at least 2005 — and intermittently even earlier going back to the 1990s — the Bluebook has presented the optimal policy path of the funds rate. An example of such a Bluebook optimal policy exhibit is in the chart pasted below, which is from the latest publicly available Bluebook, from the December 2007 FOMC meeting. Technical documentation can be found here.
Where I freely drew in (red dotted lines) the sort of path taken by the funds rate and ‘state variables’ (unemployment and inflation) under an assumed 2% inflation goal. Note how the actual paths quickly go “off the charts”!