Monetary policy rules can be used both for prescriptive and descriptive purposes, but it’s important to be clear about which purpose one has in mind. A policy rule estimated over a period which included the Great Inflation of the 1970s, for example, might be a good description of policy during that period, but it would be a terrible prescription for policy today. Similarly, a policy rule estimated over a period which included the 2003-2005 period, when rates are unusually low, would not be a good prescription, in my view, for policy today.
Misunderstandings about whether a particular rule is meant to be descriptive or prescriptive can thus lead to policy mistakes. Consider this passage from the March 18, 2011 issue of JP Morgan’s Global Data Watch (p 16): “The original Taylor rule was descriptive and meant to match how Fed policy was set in the 1987-1992 period. Subsequently, some researchers found that variants of Taylor rules were optimal in certain economic models, and so could also be prescriptive. However, those classes of models were usually quite restrictive, such as assuming policy was not at the zero bound, or that the central bank only tried to influence the short end of the curve. In fact, very few optimal policy models even incorporate multi-period interest rates.”
(photo credit: quimby)