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Fed’s New Chair Needs a Policy Rule

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Fed’s New Chair Needs a Policy Rule

November 5, 2017

President Trump has nominated Jerome Powell to be the next Federal Reserve Chair, ending speculation over who will succeed Janet Yellen as chief monetary policymaker. The President’s pick also removes an important element of uncertainty associated with the transition between Chairs, because Powell – already a member of the Fed Board since 2012 – has expressed approval of Yellen’s plans to raise rates gradually, while also scaling back the size of the Fed’s balance sheet, during the coming years. But even as he provides continuity at the Fed, Powell has an opportunity to enhance the institution’s credibility and thereby make his own positive contribution to the policymaking process. He can do this by describing the Fed’s actions under his leadership with consistent reference to a monetary policy rule.

The 2017 Financial CHOICE Act, which would require the Fed to adopt and announce a monetary policy rule, remains on hold as Congress focuses on more pressing issues of tax reform. In tapping Powell as his preferred candidate for Federal Reserve Chair over more forceful advocates of rule-based monetary policymaking, President Trump also suggested, implicitly, that he too does not view the Fed’s adoption of a rule as his strongest priority. Nevertheless, a rule like the one proposed by John Taylor in 1993 remains fully consistent with the Fed’s statutory dual mandate to stabilize prices and maximize employment. New Chair Powell could safely use it, as a tool for accomplishing more effectively the goals that the legislature and executive have already approved.

The original Taylor rule prescribes that the Fed adjust its federal funds rate target r relative to its long-run level r* in response to movements in inflation p away from its 2 percent target and changes in the output gap y according to

r = r* + 1.5(p – 2) + 0.5y.

By raising rates in response to rising inflation or an acceleration of real growth beyond potential, and lowering rates in the face of falling inflation or a deceleration of growth below potential, this rule works automatically, as noted above, to achieve both sides of the Fed’s dual mandate.

John Taylor originally measured inflation in his rule by changes in the GDP deflator and the output gap by percentage-point deviations of real GDP from a linear trend; he also set the long-run nominal interest rate r* equal to 4, the sum of the 2 percent inflation target and an assumed 2 percent long-run real interest rate. As the new Fed Chair, Powell may wish to implement the rule with different choices, reflecting changes in the economy that have occurred since the early 1990s. Today, for instance, the Fed’s inflation target refers to changes in the price index for personal consumption expenditures (PCE) instead of the GDP deflator. Likewise, a measure of the output gap based on the percentage deviation of real GDP from the Congressional Budget Office’s (CBO) estimate of potential real GDP would work better than a simple linear trend in accounting for gradual shifts in growth prospects brought about by demographic, technological, and other non-monetary factors. Finally, Fed policymakers now believe that some of the same non-monetary factors that have reduced the economy’s growth potential have also lowered real interest rates: thus, a value of r* = 3 is now their expectation for the long-run federal funds rate.

Presently, the year-over-year core PCE inflation rate is 1.3 percent, while the CBO output gap stands at 0.2 percent. Feeding these numbers into the Taylor rule with r* = 3 yields a prescribed federal funds rate target of 2 percent. By comparing this rule-based number to the current funds rate target between 1 and 1.25 percent, incoming Chair Powell can clearly explain why additional interest rate increases must be implemented soon, simply to bring monetary policy back to where it should be, given the economic data on output and inflation. Moreover, as inflation gradually returns to its 2 percent target, the same rule will prescribe settings for the funds rate closer to its own long-run value of 3 percent. The Chair can then explain that additional policy tightening is necessary, to prevent inflation from overshooting its target.

If, on the other hand, the recent decline in core inflation persists, or real economic growth in 2018 fails to meet potential, the same version of the Taylor rule may require postponement of the interest rate increases that have already been discussed. By focusing the public’s attention of this rule now, Chair Powell will acquire the credibility he’ll need to respond effectively to these – or any other – unexpected changes, without raising doubts over his commitment to either stabilizing prices or maximizing sustainable growth and employment. A monetary policy of this kind is exactly what the new Fed Chair needs to meet any challenge going forward.

Peter Ireland is a professor of economics at Boston College and a member of the Shadow Open Market Committee.

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