Policy Rules and Economic Performance

Abstract

Monetary policy evaluation has evolved over time from fixed rules versus discretion to policy rules versus constrained discretion. We propose a metric to evaluate monetary policy rules by calculating quadratic loss ratios, the (inflation plus unemployment) loss in high deviations periods divided by the loss in low deviations periods, with policy rules with higher loss ratios preferred to rules with lower loss ratios. The central result of the paper is that rules with larger coefficients on inflation than on the output gap have higher loss ratios (and are therefore preferred to) rules with equal coefficients or rules with higher coefficients on the output gap. This result is robust to policy lags between one and two years, different weights on inflation loss than on unemployment loss, various definitions of high and low deviations periods, and time varying equilibrium real interest rates. We conclude that the Fed should “constrain” constrained direction by responding more strongly to inflation gaps than to output gaps.