That's the title of a speech delivered by Federal Reserve Governor Ben Bernanke to the National Economists Club in Washington D.C. last Thursday.  It is required reading for anyone interested in the process of monetary policymaking.

Governor Bernanke starts by describing the wrong way to think about monetary policy.

Superficially, the FOMC decision process may appear straightforward. A commonly used analogy takes the U.S. economy to be an automobile, the FOMC to be the driver, and monetary policy actions to be taps on the accelerator or brake...

I wish it were that easy. Unfortunately, the simplistic view of monetary policymaking derived from the automobile analogy can be seriously misleading, for at least two reasons.

First, policymakers working to keep the economy from going off the road must deal with informational constraints that are far more severe than those faced by real-world drivers...

The second problem with the automobile analogy arises from the central role of private-sector expectations in determining the impact of monetary policy actions...

The current funds rate imperfectly measures policy stimulus because the most important economic decisions, such as a family's decision to buy a new home or a firm's decision to acquire new capital goods, depend much more on longer-term interest rates, such as mortgage rates and corporate bond rates, than on the federal funds rate. Long-term rates, in turn, depend primarily not on the current funds rate but on how financial market participants expect the funds rate and other short-term rates to evolve over time.

He then suggests that monetary policy is more productively thought of as a framework that guides the central bank in its decision-making process, and offers two alternatives for consideration.  The first:

Under a simple feedback policy, the central bank's policy instrument--the federal funds rate in the United States--is closely linked to the behavior of a relatively small number of macroeconomic variables, variables that either are directly observable (such as employment or inflation) or can be estimated from current information (such as the economy's full-employment level of output)...

A classic example of a simple feedback policy is the famous Taylor rule (Taylor, 1993). In its most basic version the Taylor rule is an equation that relates the current setting of the federal funds rate to two variables: the level of the output gap (the deviation of output from its full-employment level) and the difference between the inflation rate and the policy committee's preferred inflation rate. Like most feedback policies, the Taylor rule instructs policymakers to "lean against the wind"...

And the second:

The second general approach to making monetary policy is what I am today calling a forecast-based policy... As the name suggests, under a forecast-based policy regime, policymakers must predict how the economy is likely to respond in the medium term--say, over the next six to eight quarters--to alternative plans for monetary policy. For example, monetary policy makers might be interested in evaluating a strategy of keeping the federal funds rate low for a period against an alternative plan that implies a gradual rise in rates...

Taking both their baseline forecast and the various risks to that forecast into account, policymakers then choose the plan that seems most likely to produce the best results overall.

Which framework best describes the way the Federal Open Market Committee operates?

At the Federal Reserve, both simple feedback and forecast-based approaches are used to provide information to policymakers. For example, FOMC members routinely compare their policy choices with both the prescriptions of various forms of the Taylor rule (as noted, a type of simple feedback policy) and the results of model simulations and forecasting exercises undertaken by staff at the Board and at the twelve Reserve Banks (as required by the forecast-based approach).

Nonetheless, according to Bernanke,

... projections of how the economy is likely to perform under different policy plans are nevertheless central to the monetary policy process in the United States; that is, the Federal Reserve relies primarily on the forecast-based approach for making policy.

He supports this case by appealing to Chairman Greenspan's description of some of the policy decisions made over the past decade.  But the next step is to introduce what might be presented as third framework, called (by Mr. Greenspan) the "risk-management approach."

Operationally, the risk-management approach differs from the forecast-based policies... in only one important respect. For simplicity, researchers have generally analyzed forecast-based policies under the assumption that policymakers care only about average economic outcomes. However, in practice, policymakers are often concerned not only with the average or most likely outcomes but also with the risks to their objectives posed by relatively low-probability events. For example, although the probability last year of a pernicious deflation in the United States was small, the potential consequences of that event were sufficiently worrisome that the possibility of its occurring could not be ignored. In that spirit, Greenspan's risk-management approach sensibly reflects the fact that the entire distribution of possible outcomes, not just the average or most likely expected outcome, matters for policy choice.

Bernanke does note that the distinction between the forecast-based (or risk-management) and feedback-rule frameworks may not be quite as stark as presented in the speech.  For example, it is quite common to think of Taylor-type rules based on forecasts of future output and inflation.  There is nothing that precludes the policymaker from running through the distribution of funds paths implied by a collection of forecasts, thus melding the two frameworks.  (The extension to the risk-management framework is apparent.)

In fact, Governor Bernanke emphasizes the key role played by communications when a central bank operates within the forecasting framework.  If those communications typically center on the forecasts of a few key variables -- like output and inflation -- and policy actions are consistent over time (in the sense that like forecasts generate like funds-rate choices), the alternative policy frameworks would be virtually indistinguishable.

For another reaction to the speech, check out this post at EconoPundit.