As you may recall, in a Taylor Rule the nominal federal funds rate depends on an equilibrium or neutral real rate of interest – which is assumed to be constant over time – the deviation of the level of economic activity from estimates that would be consistent with long-run price stability and the deviation of inflation from the central bank’s target. As I have noted elsewhere, the Taylor Rule formulation has a number of characteristics that make it a useful input into the policy-setting process. First, it very explicitly focuses on the two parameters – the long-term inflation objective and the level of potential output consistent with that objective – that map directly to the Federal Reserve’s dual mandate objectives. Second, standard Taylor Rules are self-equilibrating. They respond to economic shocks and forecast errors in a way that pushes the economy back toward the central bank’s objectives. Market participants incorporating information about the rules in their price-setting decisions helps keep inflation expectations well-anchored. Third, academic research shows that Taylor-type rules typically perform quite well across a wide range of economic models. This is important because we want guides to policy that are robust; that is, guides that are not overly sensitive to model-specific assumptions about how the economy works, or how households and businesses alter their expectations and behavior in response to changes in monetary policy.5  5  6  See Conducting Monetary Policy: Rules, Learning and Risk Management.
BIS central bankers’ speeches  7  Conclusion In my remarks today, I have provided my current thinking about the U.S. growth and the inflation outlook, and the implications for monetary policy. To sum up, the U.S. economic outlook looks brighter, with growth likely to be somewhat above the trend of the past five years. The risks to growth appear generally balanced, without unusually high risks that growth will either be much stronger or weaker than my forecast. On inflation, I remain confident, despite the recent softening, that inflation will begin to move up towards our 2 percent objective next year. This move will not likely happen immediately, however, given the recent weakness in energy prices and the fact that non-energy import price trends are also likely to soften a bit over the near-term. With respect to monetary policy, I believe that market expectations as captured by the most recent New York Fed’s surveys of primary dealers and market participants are reasonable – with lift-off expected to take place sometime around the middle of next year. But, life is uncertain and my judgment of the appropriate timing could change in response to incoming data and other factors that change the economic outlook. When we do begin to tighten monetary policy, the pace of tightening will depend not only on the outlook but also on how financial market conditions respond as we begin to remove monetary policy accommodation. Financial market conditions are an important transmission mechanism of monetary policy.