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Proposed Fed rule gives mixed signals on rates: study

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[November 25, 2014]  By Ann Saphir

SAN FRANCISCO (Reuters) - A rule that some U.S. lawmakers want the Federal Reserve to follow when setting monetary policy is now giving conflicting signals on where interest rates should be, a San Francisco Fed study published on Monday showed.

The so-called Taylor rule, named after its author Stanford University professor John Taylor, delivers an estimate for the appropriate level of interest rates based on the rate of inflation and the level of economic slack.

Recently, however, the equation has generated contradictory policy guidance, spitting out a negative interest rate when economic slack is measured in terms of economic growth, but a positive interest rate when slack is measured in terms of unemployment, the paper argued.

"Determining whether the economy is overheating or underperforming is critical for monetary policy," Early Elias, Helen Irvin and Oscar Jorda, the authors of the paper, wrote. "Our analysis highlights the difficulties of using the Taylor rule as a practical guide to implementing monetary policy in real time."

Earlier this year, some Republicans in the House of Representatives embraced the Taylor rule as one they would like the Fed to follow. Fed Chair Janet Yellen - who used to run the San Francisco Fed - has balked at the idea. The San Francisco Fed paper did not mention the Republican proposal.

Taylor, contacted by Reuters about the research, said he "completely" disagrees with both its premise and its conclusions, arguing that the authors use a version of his rule that over-emphasizes the importance of economic slack.

He also rejected as "silly" the argument that because there is uncertainty over the amount of slack in the economy that monetary policymakers should just jettison the rules.

"Uncertainty exists in the real world; you can't ignore it whether you use rules or discretion," Taylor said.

For much of the time since the Great Recession, policymakers consulting the Taylor rule concluded it prescribed a deeply negative policy rate. Since negative interest rates are difficult to engineer, the Fed resorted to unconventional methods of policy easing, including massive bond-buying programs.

The Fed wound down its latest bond-buying stimulus last month, but is not expected to begin to raise rates from their current near-zero levels until the middle of next year.

Monday's research suggests that even if the Fed adopted the Taylor rule, there still could be room for doubt as to what interest rate it prescribes.

(Reporting by Ann Saphir; Editing by Paul Simao and Andrea Ricci)

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