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Optimal control theory: Embracing it in monetary policy

I still remember the days of studying dynamic optimization in my advanced macroeconomic class in the MPA/ID program. A few students like myself once moaned about the difficulty and “irrelevance” of dynamic optimization to the real world. Indeed, “optimal control”, a key approach to dynamic optimization, was developed in the 1950s during the space race, and it appears to be so remote from my daily life.

Not anymore.

Using the “optimal control” approach, two new working papers written by Federal Reserve staff — “Aggregate Supply in the United States: Recent Developments and Implications for the Conduct of Monetary Policy” and “The Federal Reserve’s Framework for Monetary Policy – Recent Changes and New Questions” — have attracted significant market attention this week, because they suggest a lower unemployment rate of 5.5% (rather than the 6.5% set out by Bernanke earlier) before triggering a tightening of policy, while also tolerating a higher rate of inflation of around 2.5% (which is higher than the informal inflation target of 2%).

But the true reason markets are listening to these two workings papers (which do not necessarily reflect the Fed’s view) is that it precisely coincides what the (likely) incoming Fed chairwoman Janet Yellen has on her mind. More than a year ago, she has already promoted “optimal control” as an alternative approach to set monetary policy. According to her speech:

Although simple rules provide a useful starting point in determining appropriate policy, they by no means deserve the “last word”–especially in current circumstances. An alternative approach, also illustrated in figure 10, is to compute an “optimal control” path for the federal funds rate using an economic model–FRB/US, in this case.

This basically says that Yellen may want to keep the interest rate longer (see the green line) than standard economic theory (in particular the Taylor rule, the red line) would imply. I read this as saying the Fed may not raise interest rate until 2017 (which would seriously put emerging markets into a “hot” spot), as Yellen suggested that this would be more effective in bringing down unemployment.

Figure 11 shows that, by keeping the federal funds rate at its current level for longer, monetary policy under the balanced-approach rule achieves a more rapid reduction of the unemployment rate than monetary policy under the Taylor (1993) rule does, while nonetheless keeping inflation near 2 percent. But the improvement in labor market conditions is even more notable under the optimal control path, even as inflation remains close to the FOMC’s long-run inflation objective.

So expect “optimal control” to be the new buzzword in finance, and be ready to embrace it! I would expect more investors and pseudo-economists will be looking up its definition on Wikipedia this week, as Janet Yellen will appear before the Senate Banking Committee’s  confirmation hearing on Thursday. I have put below my favorite definition by Gavyn Davies:

Optimal control is a method which has been borrowed by economists from applied mathematics and sciences, notably engineering. In the field of monetary economics, it involves taking a macro-economic model, and running multiple simulations (sometimes in the millions), using different combinations of interest rates and the Fed balance sheet to derive projected time paths for the central bank’s objectives (inflation and unemployment) in the years ahead. The simulation which produces the best outcome for the Fed’s objectives is then used to select the optimal setting for policy.

Let’s wait and see what the U.S. senators can learn from Yellen in a few days.

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