With respect to the strength of our responses to output gaps and inflation gaps, I think the Committee hasn’t been as gradual or as damped in its responses as the equations say it has. In my view there are a couple of points indicative of biases there. One is that the Committee has been forward-looking, so we’re really looking at forecasts and not at existing output gaps. We can often bring information to bear that says that a particular shock will likely go away and we don’t need to react so strongly to it.
So I think the wrong stuff is on the right-hand side of these Taylor rules; the Committee is doing much more than looking at the current levels of those two gaps. The second point is that these estimates are made on the assumption of a constant inflation target, in this case from 1987 through the present. I don’t want to get into a discussion of whether it should or should not have been constant. But I do believe that, from 1987 at least into the second part of the 1990s, the Committee surely did not have a constant inflation target. A number of the former members of this Committee talked about an opportunistic approach to reducing inflation. Inflation was higher than it needed to be over the long run, but there wasn’t any extraordinary effort to reduce it. The models wanted us to be stronger in reducing inflation because they had a lower inflation target than the Committee and the Committee didn’t react to the model’s target but to its own. I think that biases the results to finding that the Committee didn’t act as aggressively as the models thought it should, when in fact it acted fairly aggressively—and aggressively enough to get some pretty darn good outcomes for the economy over the past twenty years.
Having said that, I think there is a valuable lesson embedded here, and it goes to the discussion you were having about policy mistakes. It’s better generally for policy to act too strongly than too weakly to developing situations. Serious policy errors have been made when policy doesn’t react aggressively enough to a developing situation. Examples are the Federal Reserve in the 1970s or the Bank of Japan in the 1990s.
That is the sort of policy error that allows expectations to get out in front. It allows a spiral to develop that becomes very, very hard to reverse. If we react too aggressively, that also can be a policy mistake. But tightening too much because we’re afraid of inflation or easing too much because we’re concerned about deflation or recession is much more easily reversed without cumulating expectational problems getting built in. So to me the lesson for the Committee from these optimal rules is that we are probably better off being a little too aggressive than being not aggressive enough in terms of the possible consequences for the economy over time.