PRSRT STD U.S. POSTAGE PAID ST. LOUIS MO PERMIT NO. 444 FEDERAL RESERVE BANK OF ST. LOUIS Federal Reserve Bank of St. Louis P.O. Box 442 THIRD QUARTER 2015 St. Louis, MO 63166-0442 VOLUME 97 | NUMBER 3 REVIEW Change Service Requested Fear of Liftoff: Uncertainty, Rules, and Discretion in Monetary Policy Normalization R E Athanasios Orphanides V I E W Human Capital and Development Rodolfo E. Manuelli Monetary Policy in Small Open Economies: The Role of Exchange Rate Rules Ana Maria Santacreu A Model of U.S. Monetary Policy Before and After the Great Recession David Andolfatto T h i r Quantitative Macro Versus Sufficient Statistic Approach: d Q A Laffer Curve Dilemma? u a Alejandro Badel r t e r 2 0 1 5 • V o l u m e 9 7 , N u m b e r 3 REVIEW Volume 97 • Number 3 President and CEO James Bullard Director of Research 173 Christopher J. Waller Fear of Liftoff: Uncertainty, Rules, and Discretion Chief of Staff in Monetary Policy Normalization Cletus C. Coughlin Athanasios Orphanides Deputy Directors of Research B. Ravikumar David C. Wheelock 197 Review Editor-in-Chief Human Capital and Development Stephen D. Williamson Rodolfo E. Manuelli Research Economists 217 David Andolfatto Monetary Policy in Small Open Economies: Alejandro Badel The Role of Exchange Rate Rules Subhayu Bandyopadhyay Maria E. Canon Ana Maria Santacreu YiLi Chien Riccardo DiCecio William Dupor 233 Maximiliano A. Dvorkin A Model of U.S. Monetary Policy Carlos Garriga Before and After the Great Recession George-Levi Gayle David Andolfatto Limor Golan Kevin L. Kliesen Fernando M. Martin 257 Michael W. McCracken Quantitative Macro Versus Sufficient Statistic Approach: Alexander Monge-Naranjo A Laffer Curve Dilemma? Christopher J. Neely Michael T. Owyang Alejandro Badel Paulina Restrepo-Echavarria Juan M. Sánchez Ana Maria Santacreu Guillaume Vandenbroucke Yi Wen David Wiczer Christian M. Zimmermann Managing Editor George E. Fortier Editors Judith A. Ahlers Lydia H. Johnson Graphic Designer Donna M. Stiller Federal Reserve Bank of St. Louis REVIEW Third Quarter 2015 i Revie w Review is published four times per year by the Research Division of the Federal Reserve Bank of St. Louis. Complimentary print subscriptions are available to U.S. addresses only. Full online access is available to all, free of charge. Online Access to Current and Past Issues The current issue and past issues dating back to 1967 may be accessed through our Research Division website: http://research.stlouisfed.org/publications/review . All nonproprietary and nonconfidential data and programs for the articles written by Federal Reserve Bank of St. Louis staff and published in Review also are available to our readers on this website. Review articles published before 1967 may be accessed through our digital archive, FRASER: http://fraser.stlouisfed.org/publication/?pid=820 . 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ISSN 0014-9187 ii Third Quarter 2015 Federal Reserve Bank of St. Louis REVIEW Fear of Liftoff: Uncertainty, Rules, and Discretion in Monetary Policy Normalization Athanasios Orphanides As the author describes it, the Federal Reserve’s muddled mandate to attain simultaneously the incom - patible goals of maximum employment and price stability invites short-term-oriented discretionary policymaking inconsistent with the systematic approach needed for monetary policy to contribute best to the economy over time. Fear of liftoff—the reluctance to start the process of policy normalization after the end of a recession—serves as an example. Drawing on public choice and cognitive psycholo gy perspectives, the author discusses causes of this problem: The Federal Reserve could adopt a frame - work that relies on a simple policy rule subject to periodic reviews and adaptation. Replacing meet ing- by-meeting discretion with a simple policy rule would eschew discretion in favor of systematic poli cy. Periodic review of the rule would allow the Federal Reserve the flexibility to account for and occa sion - ally adapt to the evolving understanding of the economy. Congressional legislation could guide the Federal Reserve in this direction. However, the Federal Reserve may be best placed to select the sim ple rule and could embrace this improvement on its own, within its current mandate, with the publica tion of a simple rule along the lines of its statement of longer-run goals. (JEL E32, E52, E58, E61) Federal Reserve Bank of St. Louis Review , Third Quarter 2015, 97 (3), pp. 173-96. he Federal Reserve has faced unprecedented challenges since the onset of the most recent recession in December 2007. The downturn was exacerbated by the most T severe financial crisis since the Great Depression and prompted an unprecedented policy response. By the time the recession ended in June 2009, it had become the longest in post-World War II history. Monetary policy has remained unprecedented since then. Massive monetary policy accommodation in the form of quantitative easing (QE) was engineered by the Federal Reserve long after the end of the recession; and, even today—six years after the end of the recession—the Federal Reserve has yet to begin the process of normalization. Does the observed delay in normalizing policy suggest a break with the past? Does it lend Athanasios Orphanides is a professor of the practice of global economics and management at the Sloan School of Management at the Massachusetts Institute of Technology. He is a former senior advisor of the Federal Reserve Board, a former governor of the Central Bank of Cyprus, and a former member of the Governing Council of the European Central Bank. This article is based on the author’s Homer Jones Memorial Lecture at the Federal Reserve Bank of St. Louis on June 3, 2015. The author thanks Jeff Fuhrer, Marvin Goodfriend, Gregory Hess, Kevin Kliesen, David Lindsey, Ed Nelson, Peter Ireland, Stephen Williamson, Paul Tucker, and participants at the lecture as well as at the 2015 meeting of the Society for Computational Economics for helpful discussions and comments. © 2015, Federal Reserve Bank of St. Louis. The views expressed in this article are those of the author(s) and do not necessarily reflect the views of the Federal Reserve System, the Board of Governors, or the regional Federal Reserve Banks. Articles may be reprinted, reproduced, published, dis tributed, displayed, and transmitted in their entirety if copyright notice, author name(s), and full citation are included. Abstracts, synopses, and other derivative works may be made only with prior written permission of the Federal Reserve Bank of St. Louis. Federal Reserve Bank of St. Louis REVIEW Third Quarter 2015 173 Orphanides support to broader concerns about the monetary policy strategy of the Federal Reserve and calls for changing the legal framework governing the institution? 1 What are the risks associ - ated with fear of liftoff? Using the current environment as a springboard, the goal of this article is to put the Federal Reserve’s policy problem in a historical perspective and assess institutional safe guards that can ensure that monetary policy contributes in the best possible manner to